Substantive Tests of Transactions and Balances: Learning Objectives

10
C H A P T E R
Substantive Tests of
Transactions and
Balances
LEARNING OBJECTIVES
After studying this chapter you should be able to:
identify and distinguish between tests of controls and
1
substantive tests of transactions, and also between
substantive tests of transactions and substantive tests
of balances;
identify the financial report assertions associated

2
with both tests of transactions and tests of balances
and how the audit objective influences the audit
procedures;
explain the specific audit objectives and the common audit

procedures traditionally used to achieve those objectives for:
cash, cash receipts and cash payments;
3
accounts receivable;
4
purchases and sales, and inventories;
5
accounts payable and cash payments;
6
non-current assets;
7
liabilities and owners equity;
8
9 identify several different audit approaches that may

be used for account balances included in the
statement of financial performance;
10 describe and understand the use of computer-assisted

audit techniques in substantive testing; and
11 appreciate the impact of assessing strategic business

risk on undertaking tests of balances.
Chapteroutline
Substantive tests of transactions and balances are used procedures, and the auditor needs to co-ordinate the
to reduce detection risk, so that the desired level of audit approach detailed in the audit program to ensure
audit risk can be achieved. Substantive tests of that the most efficient and effective combination of
transactions are designed to substantively verify the audit procedures is used.
dollar value of transactions. Substantive tests of No matter what audit strategy is adopted, the
balances are audit tests that substantiate the ending auditor must undertake substantive tests and usually
balance of a general ledger account. These substantive makes considerable use of direct tests of balances. In
tests either provide reasonable assurance of the audits of the financial reports of small businesses,
validity and propriety of a transaction or balance or many auditors rely almost exclusively on them. The
identify monetary misstatement in it. A monetary following discussion of substantive tests considers
misstatement may be caused by a variety of factors, their objectives. For each major financial report
but in all cases the effect on the financial report is component, the specific objectives are explained and
either to overstate or to understate the balance. In the common procedures used to achieve them are
designing audit programs for account balances, the discussed. The components are considered in the
auditor is concerned with whether the balance is following order: cash; accounts receivable; inven-
overstated or understated by a material amount. tories; accounts payable; non-current assets and
Tests of controls and substantive tests of transactions liabilities and owners equity; and the statement of
and balances are two of the main evidence-gathering financial performance.
Relevantprofessionalguidance
Australian International
AUS 502 Audit Evidence ISA 500 Audit Evidence
AUS 504 External Confirmations ISA 506 External Confirmations
AUS 506 Existence and Valuation of Inventory ISA 501 Audit EvidenceAdditional Considerations for
Specific Items
AUS 526 Auditing Fair Value Measurements and ISA 545 Auditing Fair Value Measurements and
Disclosures Disclosures
AGS 1002 Bank Confirmation Requests IAPS 1000 Inter-Bank Confirmation Procedures
AGS 1060 Computer Assisted Audit Techniques IAPS 1006 Computer-Assisted Audit Techniques
learning
objective 1
RELATIONSHIP BETWEEN EVIDENCE-GATHERING
PROCEDURES
In this section we examine the relationship between tests of controls and substantive tests of
transactions. As both these tests involve transactions, in many instances transactions selected for
examination are tested for compliance with controls as well as determining whether monetary
errors have occurred, giving rise to the concept of dual-purpose testing. Later in this section we
also distinguish between substantive testing of transactions and balances.
Relationship between tests of controls and

substantive tests of transactions
Tests of controls detect departures from prescribed controls. However, tests of controls do not directly
measure monetary error in accounting records. Substantive tests must be performed to determine
whether monetary errors have occurred. The auditors judgment of the likelihood of monetary errors,
based on tests of controls, determines the extent of substantive tests considered necessary.
436 PA R T T H R E E Te s t s o f c o n t r o l s a n d t e s t s o f d e t a i l s
Accounting records provide the underlying evidence for financial reports. The auditors
objective in making substantive tests of transactions is to obtain reasonable assurance that the
accounting records are accurate and reliable. The auditors approach in substantive tests of
transactions is to inspect underlying documents, to trace the flow of transactions through the
system and to recompute for clerical accuracy.
The direction of the trace determines the objective to be satisfied. For example, tracing from a
source document to the accounting record provides evidence of completeness of the accounting
records, that is, it detects errors of understatement. Tracing from the accounting record to the
source document (commonly called vouching to the source document) provides evidence of
occurrence, that is, it detects errors of overstatement. Usually some tests are made in both
directions. The extent of testing in a particular direction depends on the auditors judgment of the
likelihood of error. When an error is detected the auditor needs to consider the cause of the error
and determine whether any change is called for in the planned nature and extent of testing.
Dual-purpose tests
Since both tests of controls and substantive tests of transactions involve inspection of documents
for individual transactions, they are usually performed simultaneously on the sample of
documents chosen. Although several tests can be performed simultaneously on the same
transaction documents, it is important to be specific about the purpose of particular procedures.
Dual-purpose tests should be narrowly defined to include only those tests that are specifically
planned to provide direct evidence of both controls and substantive matters.
In a broad sense, all audit tests are dual-purpose tests. Whenever an error is discovered in a
test, there is some evidence of a breakdown in controls. Whenever no errors are discovered, there
is indirect evidence that controls are operating. This is the reason that some auditors say the
evaluation of controls is not final until the audit is completed. Substantive audit tests can always
provide some additional evidence of the functioning of controls.
In a true dual-purpose test, different procedures are performed to satisfy different objectives,
but they are performed using the same documents at approximately the same time. For example,
controls in the processing of purchase invoices may require a clerk to compare the data with
supporting documents, check the classification in the purchases journal, recompute amounts and
initial the invoice to indicate performance of the procedures. The auditor inspects documents for
the clerks initialsthe test of controlsand recomputes and retraces the clerks other procedures,
which satisfies several substantive objectives.
On the other hand, if controls are absent or not functioning, there will be no testing of controls,
and more extensive substantive testing (of either transactions or balances) will be necessary. Thus,
in practice, a sample of transactions selected to test controls will virtually always be a dual-
purpose test, or the sample of transactions may be selected for substantive tests only.
Relationship between substantive tests of

transactions and substantive tests of balances
Substantive tests of transactions can also be distinguished from substantive tests of balances. If the
account balance is affected by many relatively small transactions, the auditor designs substantive
tests of balances directed to selected items (e.g. individual customers, inventory items) which
aggregate to create the ending balance. This commonly occurs for the accounts receivable and
inventory balances. Consider the extract of the accounts receivable subsidiary ledger (overleaf):
CHAPTER 10 Substantive tests of transactions and balances 437

Customer Year-end balance Transactions for Able
Able 5000 Sale 2000

Receipt (1000)
Sale 4000
Baker 500
Chan 1000
The balance of accounts receivable would be composed of the balances of many customers.
Consider customer Able, whose ending year balance of $5000 is composed of three transactions. If
the auditor verifies the $5000 ending balance (such as through confirmation procedures discussed
later in this chapter) this is a substantive test of balances. If the auditor verifies the dollar value of the
individual transactions comprising the $5000 (such as by verifying sales invoices and remittance
advices associated with cash receipts transactions) this is a substantive test of transactions.
Tests of transactions (both tests of controls and substantive tests of transactions) are usually
performed for major classes of transactions that are repetitive and large in volume. The major
classes of transactionssales, purchases, cash receipts and cash disbursementsaffect statement
of financial position accounts in the following manner:
Accounts receivable Cash Accounts payable
Beginning balance Beginning balance Beginning balance

Additions (sales DR) Additions (purchases CR)
Reductions (cash receipts CR) Additions (cash receipts DR)
Reductions (cash disbursements CR) Reductions (cash
disbursements DR)
Ending balance Ending balance Ending balance
In the abstract, if beginning balances were tested in the previous year, it would be possible to
indirectly test the major transactions by substantive tests of balances of these statement of
financial position accounts. There might be other sources of cash receipts and cash
disbursements, but they would be substantiated by direct tests of balances of the statement of
financial position accounts affected. Substantive tests of balances of statement of financial
position accounts are generally preferred because there are fewer items in the ending balance than
there are transactions that affect the balance, and there is generally more persuasive evidence
available to support the ending balance.
Note also that the substantive tests of balances of statement of financial position accounts
indirectly test the statement of financial performance account balances (sales and expenditure). For
example, the testing of accounts receivable will verify the sales that gave rise to this asset. Taking one
step back from this abstraction, it is obvious that even in a highly condensed statement of financial
performance there is normally more than one category of expenditures. This means some tests of
recording accuracy as to account classification would be necessary. However, it is still possible to
plan an audit that consists primarily of substantive tests of balances of statement of financial
position accounts, with selected tests of transactions for particular specific audit assertions.
This kind of auditwith emphasis on substantive tests of balances of statement of financial
position accountsis, in fact, the approach typically used for small businesses. It is also used
when a large entity has material deficiencies in the processing of particular classes of transactions.
This approach is called the substantive approach to an audit. Generally, it is the most efficient and
effective means of auditing the financial report of a small business. It is especially efficient if the
auditor designs effective analytical tests for those specific audit objectives, such as statement of
financial performance, account classification and those related to the completeness assertion,
that are not achieved by substantive tests of balances. For a large business, however, the
substantive approach is often not cost effective for the following reasons:
The number of items in ending balances, while still fewer than the number of transactions that
affect the balances, is relatively large.
The accounting system for processing major classes of transactions is generally well designed
and produces more reliable accounting data because management in a large entity has to rely
extensively on the accounting data to monitor and control the business.
There are generally enough employees to achieve effective separation of duties.
In these circumstances, by testing the processing of transactions the auditor can restrict the
substantive tests of balances that would otherwise have been undertaken.
Q u i c k r e v i e w
1 Dual-purpose tests are specifically planned to provide direct evidence concerning both
controls and substantive matters in order to satisfy different audit objectives. They are
performed using the same documents at approximately the same time.
2 In practice, if documents are selected to test controls they will virtually always be
examined to achieve substantive testing objectives and the tests are classed as dual-
purpose tests. Documents may also be selected with no intention of testing controls (for
substantive purposes only) and these are classed as substantive tests of transactions.
3 Account balances are composed of a series of transactions. It is possible to substantively
verify either the transactions comprising the account balance or the account balance itself.
FINANCIAL REPORT COMPONENTS AND AUDIT 2 learning

objective
OBJECTIVES FOR DIRECT TESTS OF BALANCES

A component of a financial report is simply a line item in the report. Generally, it is more precise
to refer to a component rather than an account balance because several general ledger accounts
are usually combined into a line item in a financial report. For example, an entity may have
general purpose bank accounts in several locations, a payroll bank account and several special
purpose accounts, with a separate general ledger account for each. However, on the statement of
financial position, all these accounts are combined in a single line item for cash. In this book, the
term account balance is often used instead of financial report component for convenience. It
should be understood to mean either an individual balance or a group of account balances in the
general ledger combined for the purpose of preparing a financial report.
The nature of the account balance and the related specific audit objectives the auditor has
developed are important considerations in determining the nature of the audit procedures that
are selected, and also their timing and extent.
Specific audit objectives

The auditor develops specific audit objectives from the broad categories of financial report
assertions introduced in Chapter 5. The broad categories are detailed in Table 10.1 (overleaf).

TABLE 10.1 Financial report assertions for account balances
Applies to
Balances, therefore Transactions, therefore

Statement of Statement of
Assertions Definitions Financial Position Financial Performance
Existence Concerned with whether assets X

or liabilities exist at a given date.
Rights and Concerned with whether an asset or X
Obligations liability pertains to the entity at a
given date and whether the entity
was a party to reported transactions.
Occurrence Concerned with whether trans- X
actions that generated financial
report accounts actually occurred.
Completeness Concerned with ensuring that there X X
are no unrecorded assets, liabilities,
transactions or other events, or
undisclosed items.
Valuation Concerned with whether an asset X
or liability is recorded at an
appropriate carrying amount.
Measurement Concerned with whether X X
appropriate amounts have been used
to record asset, liability and expense
transactions in the proper period.
Disclosure Concerned with whether an item is X X
disclosed, classified and described in
accordance with the applicable
financial reporting framework.
The auditor selects procedures to achieve each of the specific audit objectives for an account
balance. These objectives are developed from the broad categories of assertions, and the nature of
an audit objective influences the nature of the procedures selected. The following descriptions
illustrate this relationship.
Existence In designing substantive tests for the assertion of existence, the auditor selects from
items contained in the account balance and obtains evidence that supports them. The logical
procedures to accomplish such objectives include physical examination, confirmation and
vouching. Note that these are tests for overstatement of the balance.
Occurrence is concerned with whether transactions that generated financial report accounts
actually occurred. Focuses on whether all transactions recorded during a period are bona fide
transactions and that no fictitious transactions have been recorded. This assertion is
concerned with overstatementnothing has been recorded and reported to inflate any
account balance. Verification of transaction occurrence includes two subordinate objectives.
The transactions should be supported by a proper internal control structure and the auditor
should evaluate the existing internal control structure underlying each of the various types of
transactions recorded during the period. Second, the auditor must ascertain that proper
documentary support exists to validate the transactions creating the various account balances.
The extent of documentary support required varies with the nature of the client and the
transaction, but some documentary support should exist for all transactions.
EXAMPLE 10.1 Relationship between existence and occurrence
The relationship between specific audit objectives for related account balances can be demonstrated
by an example from the sales cycle. The financial report assertion of existence or occurrence is
translated into specific audit objectives as follows:
Financial report assertion Statement of financial position Statement of financial

(Existence) performance (Occurrence)
Existence or occurrence Accounts receivable are authentic Reported sales to customers
obligations owed by customers at actually occurred during the
the balance date period covered by the profit
and loss statement
Procedures to achieve the objective related to existence for accounts receivable should also aid in
achieving the objective related to occurrence for sales. Directly testing the accounts receivable balance
for overstatement (existence) simultaneously indirectly tests the occurrence of sales.
Procedures to achieve objectives for statement of financial position and statement of financial
performance account balances in the sales cycle are often a combination of tests of transactions for
sales and cash receipts and direct tests of balances for accounts receivable.
Completeness In designing substantive tests for the assertion of completeness, the auditor
identifies evidence indicating items that should be included in the account balance or class of
transactions and investigates whether they are in fact included. A logical procedure is to trace
from documentation created when transactions originate, or other evidence of origination, to
the account balance. In other words, the direction of the test is the opposite of that for objectives
related to the existence assertion. Note that these are tests for understatement of the balance.
Rights and obligations In designing substantive tests for the assertion of rights and
obligations, ownership must be verified for many assets. The auditor must ascertain that the
assets are owned/controlled by the client and that the liabilities are those of the client.
Although possession may be accepted as evidence for ownership of some assets, the auditor
must take further steps in ascertaining that many of the recorded assets are in fact
owned/controlled by the client.
The auditor may also need to obtain information on the terms of the agreement between
the parties to the exchange transaction that created the right or obligation. Common
procedures used to accomplish such objectives are inquiry and inspection of contracts,
agreements, minutes and similar documentation. Many of these are called general procedures
because they are not directed to a specific account balance. For example, reading the minutes
of meetings of the board of directors is a general procedure used to obtain evidence relevant to
many account balances that specific transactions pertain to the entity.
EXAMPLE 10.2 Difficult areas associated with rights and obligations
Inventories held by the client under consignment arrangements exist, but may not be owned by the
client. The auditor must therefore determine that inventories as represented on the balance sheet do
not contain significant amounts of consigned inventories owned by others. It is also possible that
inventories out on consignment at distributors at the time of counting stock may still be owned by
the audit client at the time of the audit, as identified by the terms of the consignment. The auditor
will have to carefully consider rightful ownership of the inventory in these circumstances.

Measurement While measurement usually relates to transactions (the valuing of assets and
liabilities is the equivalent of the measuring of the dollar value of transactions), two aspects of
measurement are clerical accuracy and cut-off. Cut-off involves checking that transactions are
recorded in the correct period and will thus affect the associated valuation of the
corresponding assets or liabilities.
Valuation In designing substantive tests for the assertion of valuation, the auditor needs to
consider the basis of valuation of the asset or liability in terms of approved accounting
standards. If the basis is historical cost less accumulated depreciation or amortisation, the likely
procedure to accomplish the audit objective is recomputation. If the basis is net realisable
value, or something similar, the likely procedures are inquiry and analytical procedures to
assess the reasonableness of managements estimation, or inspection of external information
on market prices. Naturally, omission of items (completeness) or inclusion of improper items
(existence) will also affect valuation. However, because the cause of these types of misstate-
ments is usually different, they are considered separately under those specific assertions.
EXAMPLE 10.3 Relationship between valuation and measurement

The following example illustrates the relationship between these two assertions for the sales cycle.
Financial report assertion Statement of financial position Statement of financial

(Valuation) performance (Measurement)
Valuation or measurement Accounts receivable are valued Transactions affecting accounts
at the amount we expected to receivable, sales and cash receipts
receive from debtors are properly measured in terms of
cash value
Direct tests of balances of accounts receivable for the specific audit objective related to valuation
(reduction of receivables to net realisable value) are concerned with the adequacy of the allowance for
doubtful debts. Transactions are not valued, they are measured. The related transactions (sales and
cash receipts) are verified to assure that the dollar value of the transactions is appropriately included
in transactions listings (sales journals and cash receipts journal).
Disclosure In designing substantive tests for the assertion of disclosure, the auditor considers
the appropriate classification, description and disclosure of the item in the financial report.
Thus the auditor will include in the audit program specific procedures to examine whether the
draft financial report meets financial disclosure requirements.
Nature of the item and available evidence

The nature of the item has an important influence on the auditors selection of audit procedures.
For example, the preceding discussion indicates that, for audit objectives related to the existence
assertion, likely audit procedures are physical examination, confirmation and vouching. For the
procedure of physical examination to be useful, the item must have a physical existence and be
present. An auditor can count cash or securities on hand, but must confirm an accounts receivable
balance with a customer or cash in a bank account with the clients bank.
Another aspect of the nature of the item is the size and volume of transactions during the
period covered by the financial report. If an account balance is affected by only a few large
transactions, the auditor may design substantive tests directed to the individual transactions that
increase or decrease the balance (assuming the beginning balance was substantiated last year) in
order to substantiate the ending balance. For example, account balances for property and
equipment, long-term debt and shareholders equity are often of this nature. This is referred to as,
and understood by auditors to be, a direct test of balances utilising a transactions approach. Thus
direct tests of balances by the transactions approach can be distinguished from tests of
transactions (as outlined earlier in this chapter) by identifying whether the concern is with specific
isolated transactions or with an entire class of transactions.
The available evidence also influences the selection of procedures to achieve audit objectives.
For example, to confirm accounts receivable with individual customers, the auditor needs a
detailed listing of the amount owed by each customer. The availability of evidence may influence
the auditors selection of procedures to achieve specific audit objectives. If a common audit
procedure cannot be applied because the evidence is unavailable, an alternative procedure may be
selected. Thus, for example, if the auditor was unable to confirm the existence of an outstanding
balance with a debtor, the existence of this balance may be confirmed by a subsequent payment
and by inspecting accompanying documentation for the amount of that balance.
1 Direct tests of balances are audit tests that substantiate the ending balance of a general
ledger account.
2 The direct tests of transactions and balances are aimed at gathering audit evidence for
the following financial report assertions:
existence
occurrence
completeness
rights and obligations
measurement
valuation
disclosure.
3 Existence means that assets or liabilities comprising an account balance actually exist. Testing
that the items which do appear should be there is a test for overstatement of the balance.
4 Occurrence is the transaction equivalent to the account balance assertion of existence.
Rather than talking about whether transactions existed we talk about gaining evidence
as to whether or not they have occurred.
5 Completeness means that all items under the entitys control that should be included in
account balances are included. The search for additional items that should be included is
a test for understatement of the balance.
6 Rights and obligations mean that the assets pertain to the entity, that the liabilities are
obligations of the entity and that the entity was a party to reported transactions.
7 Measurement refers to clerical accuracy, and that assets are not misstated, by ensuring
transactions are recorded in the correct period (cut-off).
8 Valuation refers to the proper valuation of assets and liabilities in accordance with
approved accounting standards.
9 Disclosure means the proper description and disclosure of assets and liabilities in the
statement of financial position.
learning
CASH, CASH RECEIPTS AND CASH PAYMENTS 3
objective
The account balance cash is directly affected by both the cash receipts and cash payments
systems. As these are both major transaction systems the auditor may undertake substantive tests
of both these systems. The auditor would be most worried about the assertions of occurrence and

completeness of transactions when undertaking substantive testing of these transactions systems.
Measurement of the dollar value will become an assertion of concern if transactions involve
foreign currencies.
The essential feature of substantive tests of the cash balance is substantiation of the clients
bank reconciliations to achieve specific audit objectives related to existence and completeness.
Most cash receipts and cash payments pass through the clients bank accounts, and thus the cash
balance at year-end should reflect what has flowed through those bank accounts. Valuation may
become an assertion of concern if the cash balance at year-end includes amounts converted from
foreign currencies. Thus, most of the direct tests of the cash balance make use of information
obtained directly from banks. Usually, cash on hand is clearly immaterial and not counted.
However, in industries that require substantial amounts of cash on hand, such as banks or casinos,
a cash count may be an important and time-consuming procedure.
It may be necessary to undertake both tests of transactions and tests of balances. Some errors
that ultimately affect cash can be detected only in tests of sales transactions and payments
transactions. For example, not invoicing a customer, invoicing the wrong amount, paying a
suppliers invoice twice or paying for goods or services not received are not detected by cash
balance procedures. However, errors confined to cash receipts and cash payments may be detected
in tests of cash transactions or by cash balance procedures. For example, omission of a cheque from
recorded cash payments or inclusion of cash received after year-end in cash receipts of the current
period might be detected by examining cash transactions or testing bank reconciliations.
Assertions, objectives and procedures

The financial report assertions, specific audit objectives and common audit procedures tradition-
ally used to achieve the objectives for auditing cash are summarised in Table 10.2. The primary
procedures are:
confirmation of balances and related information for all general bank accounts; and
tests of the clients bank reconciliations.
General procedures and scanning aim to identify restrictions on cash or cash commitments
arising from such things as escrow accounts (monies kept in the custody of a third party until
some condition has been fulfilled) or compensating balance arrangements. Generally, valuation of
cash is not a significant concern unless the company engages in foreign currency transactions.
Rights and obligations to cash are generally established by the procedures used to achieve
objectives related to existence, completeness and valuation.
Confirmation of bank balances

The auditor commonly confirms the year-end cash balance by direct correspondence with all
banks with which the client has had accounts during the period. Confirmation procedures
provide evidence that the cash in the statement of financial position exists at the balance date
and that it is owned by the entity and is not restricted or committed. Audit guidance on bank
confirmation procedures is provided by AGS 1002, Bank Confirmation Requests. Bank
confirmation requests ask a bank to provide independent confirmation of the audit clients
account balances and other information held by the bank on behalf of the client, including
securities, treasury management instruments and documents. Two standard bank confirmation
request forms have been developed in conjunction with the Australian Bankers Association and
are recommended for use by auditors:
TABLE 10.2 Assertions, objectives and procedures for cash balances
Financial report Common audit procedures

assertion Specific audit objective to achieve objectives
Existence Cash in the statement of financial Bank confirmation

position exists at the balance date. Tests of bank reconciliations
Occurrence The transactions giving rise to cash Sight supporting documentation. For
receipts and cash payments occurred cash receipts, sight remittance advice;
during the period. for cash payments, sight documents
(Note: relates to tests of cash receipts supporting payment
and cash payments transactions.)
Completeness Cash in the statement of financial Tests of bank reconciliations

position includes all cash items at the
balance date.
Rights and Cash in the statement of financial Bank confirmation

obligations position is owned by the entity and General procedures
not restricted or committed.
Measurement Cash receipts and payments are Sight supporting document to verify
recorded in the correct amount dollar amount of transactions
and in the correct period. Check last cash receipts and cash
payment recorded before balance date
and first cash receipts and cash payments
recorded after balance date are
recorded in the correct period (cut-off)
Test clerical accuracy of bank reconciliation
Valuation Cash in the statement of financial Tests of bank reconciliations

position is stated at the correct amount.
Disclosure Cash balances are properly described General procedures

and classified in the statement of Scanning of cash receipts and cash
financial position and related payments journals
disclosures are adequate.
1 Bank ConfirmationAudit Request (General) The information contained on this

confirmation relates to the normal banking activities and is used to confirm cash. A standard
form is contained in Appendix 1 to AGS 1002 (IAPS 1000).
2 Bank ConfirmationAudit Request (Treasury Operations) The information to be confirmed
or requested in this confirmation relates to the entitys treasury operations and use of treasury
management instruments. A standard form is contained in Appendix 2 to AGS 1002.
The standard Bank ConfirmationAudit Request (General) requests the following:
Details of all account balances in favour of the client at a certain date (usually balance date).
This includes details of any current accounts, interest-bearing deposits, foreign currency
accounts, convertible certificates of deposit and money market accounts.
Details of all account balances owed by the client to the bank at a certain date (usually balance
date) in respect of overdraft accounts, bank loans and term loans, and details of repayment
terms.
Promissory notes and bills of exchange held for collection on behalf of the audit client.
The audit clients other liabilities to the bank.
Items held as security for the audit clients liabilities to the bank.
Accounts opened or closed during the 12 months prior to confirmation date.

Any sealed packets, locked boxes or security packets held on behalf of the audit client.
All available unused limits and facilities as at confirmation date.
Any other details relating to any financial relationships not dealt with under the above points.
The auditor should complete all known details on the confirmation request before forwarding
three copies to the bank. The bank is required to ensure that all details supplied are as at the
confirmation date, to list all relevant information from details contained in its records and to
confirm the details provided by the auditor as to correctness. Any variation is marked in red on all
copies, and any information not included on the confirmation request by the auditor is inserted
in red. All three copies of the confirmation are to be signed: the original is returned directly to the
auditor, the duplicate forwarded to the client and the triplicate copy retained by the bank.
The standard form contains a disclaimer that the certificate has been completed from records
held at the branch level. The bank is therefore unable to warrant the correctness of that information
and thus disclaims all liability. The effect of the disclaimer is discussed in AGS 1002.09.10. While the
disclaimer may limit the liability of the bank to the auditor, the legal advisers of the Auditing and
Assurance Standards Board are of the opinion that the disclaimer does not affect the information
obtained from a bank confirmation request in terms of its reliability as appropriate audit evidence.
The auditor can reasonably rely upon information given by the bank provided it is not clearly wrong,
suspicious, internally inconsistent, ambiguous or in conflict with other evidence gathered during the
course of the audit. When there is evidence to suggest that the information provided by the bank is
inaccurate or incomplete, the auditor contacts the bank and requests clarification in writing.
In view of this disclaimer and notification by the Australian Bankers Association that the
present recording systems of banks do not necessarily maintain together all information for
different entities that form part of an economic entity or all accounts of a customer, an auditor
cannot rely solely on the standard form to satisfy the completeness assertion. An auditor who
believes that there is a risk that material accounts, agreements or transactions exist of which the
auditor is unaware should contact the bank and request further information.
Tests of a clients bank reconciliations

The essential objective of testing a clients bank reconciliations is to substantiate that the balance
confirmed with the bank agrees with the clients cash accounting records. Differences are caused by
deposits in transit, outstanding cheques and other reconciling items. The auditors objective is to
obtain reasonable assurance that reconciling items are authentic, complete and treated accurately.
The extent of testing of the clients reconciliations varies depending on the assessed level of
control risk. Recall that the auditor plans for three assessment levels: low, medium or high.
Possible procedures for a clients reconciliation are as follows:
1 Compare amounts on the reconciliation with totals in the bank statement, general ledger and
cash receipts and cash payments records, including a comparison of the balance per bank with
the amount confirmed by the bank.
2 Test the clerical accuracy of the reconciliation.
3 Compare deposits in transit on the reconciliation with deposits appearing in the subsequent
periods bank statement and consider whether the time lag between the end of the period and
recording by the bank is reasonable.
4 Vouch other reconciling items in the reconciliation to supporting documents.
5 Consider the need to investigate outstanding cheques or other reconciling items that have not
been cleared.
(Large or unusual items are always investigated.)
When the level of control risk is assessed as low, substantive procedures might be confined to
scanning the client reconciliations and comparing balances per bank to bank confirmations. A
medium assessed level might result in applying the procedures listed above at year-end, together
with some additional procedures described below.
If the level of control risk is assessed as high, the auditor extends the substantive procedures in
testing the clients reconciliation by examining the individual details of reconciling items. The
individual supporting documents are examined and traced to the cash accounting records.
Outstanding cheques that did not clear are traced to cash payment records, and old or unusual
items are thoroughly investigated and resolved.
Extended cash procedures

When control risk is assessed as high because of deficiencies in the internal control structure,
there is usually a greater risk of fraud. A high control risk is unusual because most clients tend to
maintain at least moderately effective controls over cash. In cases of high control risk, a common
audit procedure is the preparation and review of a bank transfer schedule. One of the more
common frauds involving cash is kiting (described in Chapter 9). Such a schedule is used when
there is a serious risk of kiting because cash controls are deficient and there are many bank
accounts and many bank transfers. When there are few bank accounts and few transfers, the
auditor scans the bank statements and cash records to determine whether deposits and
withdrawals between bank accounts are recorded in the same and the correct period. A bank
transfer schedule lists all transfers and the dates of recording on the books and bank statements.
1 The major assertions of interest to the auditor in testing the account balance of cash are
existence and completeness, and valuation if foreign currencies are included.
2 The major assertions of interest to the auditor in substantively testing the associated
transactions of cash receipts and cash payments are occurrence and completeness, and
measurement if transactions involve foreign currencies.
3 The essential feature of direct tests of the cash balance is substantiation of the clients
bank reconciliations.
4 The standard bank confirmation requests are used to help confirm information from the
clients banks.
5 Cash on hand is usually immaterial and not counted.
learning
SALES, CASH RECEIPTS AND ACCOUNTS 4
objective
RECEIVABLE
The essential feature of direct tests of balances for accounts receivable is emphasis on specific
audit objectives related to existence and valuation. For the related transactions of sales and cash
receipts the major assertions are occurrence and measurement. In practice there is usually an
emphasis on direct tests of balances, primarily for reasons of audit efficiency. These are achieved
primarily by confirmation directly with customers (although recently there has been an increased
emphasis on reviewing subsequent receipts rather than direct confirmations) and audit work
based on a review of the aged trial balance of accounts receivable. As explained in more detail
later, the aged trial balance is the basic work paper schedule in the receivables area because of
audit efficiency considerations.

Table 10.3 summarises the financial report assertions, specific audit objectives and common audit
procedures traditionally used to achieve the objectives for accounts receivable and related
account balances. The common audit procedures listed are the primary procedures traditionally
used to achieve the related specific audit objective. As applied in the accounts receivable area, the
procedures have the following features:
Confirmation Requests are mailed directly to selected customers, asking them to confirm an
amount owed at a date specified in the request. This procedure has lost prominence in recent
years, because of its failure to adequately address the important assertion of valuation
(discussed further in a separate section below). However, because it is still relatively important
in many audits, and demonstrates the evidence-gathering technique of external confirmations
in general, it is explained further (below).
Subsequent receipts review The auditor verifies whether the amount in outstanding
receivables is subsequently received. This provides the auditor with evidence that the debt
existed, and evidence of the amount that was collectible (valuation assertion). As it covers both
of the major assertions for accounts receivable, in many cases it is preferred to confirmation
procedures. Because of the growing importance of this technique, it is also discussed below, as
an alternative procedure to confirmation.
Cut-off This audit procedure is designed to determine that all significant transactions of the
current period are recorded and no significant transactions of the next period are recorded, as
of a specified date. For accounts receivable, cut-off tests are concerned with shipments and
cash collections. The auditor identifies the numbers of the last prenumbered shipping
document and the last prenumbered sales invoice for the period and determines that lower
numbers are recorded in the current period and higher numbers in the next period. If
documents are not prenumbered or the sequence is not accounted for, the auditor examines
all sales transactions above a specified amount within a few days before and after the end of
the period, to test proper cut-off. Cash collection cut-off is tested by identifying the last cash
receipt recorded in the period and comparing the date to the date of deposit in the bank. The
as of date for cut-off tests for receivables should be the same as that used for debtors
confirmation. A review of credit notes issued after the end of the period is also undertaken in
order to identify transactions from the previous period that may require adjustment.
Analytical procedures In the accounts receivable area, these include comparison of amounts
and ratios for relationships between sales and receivables, allowance accounts and sales, and
sales and cost of sales. Comparisons are made to previous periods, budgets and information
on unit quantities (units shipped to units billed).
Tests of sales transactions Tests of sales transactions are usually dual-purpose tests, having
both control and substantive elements. With regard to substantive testing, they can be especially
useful for testing assertions that arent well tested by other audit procedures, in particular the
completeness assertion. This is because the primary evidence-gathering procedures in this
areaconfirmation and subsequent receipts revieware directed to other assertions, especially
existence and valuation. The auditor may rely on controls to ensure that all transactions that
should be included are actually included. If the audit approach does not include tests of controls
related to completeness of sales transactions, the auditor has to consider the need for transaction
testing as part of direct tests of the receivable balance. The transactions test that is relevant to
completeness of receivables is tracing from shipping documents to sales invoices. In practice,
analytical tests of sales and receivables, combined with consideration of the results of audit
procedures applied to inventory, are often considered sufficient for the assertion of
completeness. (Note that unrecorded sales should also result in inventory shrinkage.)
General procedures These procedures, such as reading minutes and contracts, are usually
applied separately to the audit, rather than in relation to specific balances. However, the results of
general procedures are considered in relation to the balances affected. For receivables, the relevant
information would concern the existence of pledging, factoring or other liens on receivables.
Inquiry and scanning Inquiries relevant to accounts receivable include the existence of non-
standard sales terms (consignment sales or other rights of return) and related-party
transactions. Scanning includes visually reviewing accounting records and financial reports in
relation to the knowledge obtained from applying other audit procedures, including reviewing
for items about which inquiries were made.
Review of aged trial balance An aged trial balance of receivables lists all customer balances as
of a specified date, and shows the total balance for each customer and the components of the
overall balance by age category, such as 30 days or below, 31 to 60 days, 61 to 90 days, and over 90
TABLE 10.3 Assertions, objectives and procedures for sales and accounts receivable

Existence Accounts receivable are authentic Confirmation

obligations owed by customers at Test from debtors subsidiary ledger to
the balance date. supporting documentation of sale
(invoice, delivery note)
Subsequent receipts review
Occurrence Sales occurred in the financial year. Vouch entries in sales journal to
supporting documentation of sale
(invoice, delivery note)
Completeness Accounts receivable include all Analytical procedures

amounts owed by customers at the Test from supporting documentation
balance date. (invoice, delivery note) to sales journal
or subsidiary ledger
Rights and Accounts receivable are owed to the General procedures

obligations entity and not pledged or subjected Inquiry and scanning
to other claims. Confirmation
Measurement Sales and accounts receivable are Cut-off (tests of cash receipts and sales
included in the correct amount and transactions)
period. Verify prices, quantity and computation on
sales invoices, prices verified to master
price list, quantity verified to shipping
documentation
Test clerical accuracy of accounts
receivable listing
Valuation Accounts receivable are presented at Review of aged trial balance

a reliable estimate of the net Analytical procedures
realisable amount. Subsequent receipts review
Disclosure Accounts receivable are properly Review the draft financial report
described and classified in the
statement of financial position and
related disclosures are adequate.

days. A periodic ageing is used by an entitys financial management to monitor collectibility
and for cash management. The auditor reviews the aged trial balance as of the balance date
with the credit manager as part of the evaluation of the reasonableness of the allowance for
doubtful debts. The older the debt, the greater the risk of the debt not being paid, thus the
greater the likelihood that an allowance has to be made for non-payment. Since the aged
trial balance is usually prepared by the client, the auditor needs to test clerical accuracy by
footing and tracing. The extent of the testing depends on the controls over completeness and
accuracy of processing sales and cash receipts.
Confirmation procedures
Up until the year 2000, AUS 504/ISA 505 required that the auditor should plan to obtain direct con-
firmation of accounts receivable or individual entries in an accounts balance, in all but
exceptional circumstances. However, in 2000 the AuASB/IAASB extended AUS 504/ISA 505 from
confirmations of receivables to cover all external confirmations undertaken by the auditor. The
standard was adjusted with the expectation of allowing the auditor the opportunity to choose
auditing procedures most suitable for the client, rather than effectively mandating procedures. In
the revised standard the auditor is required to determine whether the use of external
confirmations is necessary to obtain sufficient appropriate audit evidence to support certain
financial report assertions. In making this determination, the auditor should consider materiality,
the assessed level of inherent and control risk, and how the evidence from other planned audit
procedures will reduce audit risk to an acceptably low level for the applicable financial report
assertions. These changes reflect the fact that accounts receivable confirmations are used much
less in practice than they were 10 years ago, and are seen as a less appropriate form of audit
procedure for assertions requiring audit attention when compared with other audit procedures. In
particular, confirmations do not provide evidence of intention of the client to pay (valuation
assertion), while procedures such as review of subsequent receipts show clearly the amount paid
attributable to amounts outstanding at balance date.
If it is decided that an accounts receivable confirmation is an appropriate procedure there are
two alternatives in the method of requesting a direct confirmationpositive and negative:
1 Positive form of debtors confirmation (most commonly used) The positive form asks the
debtor to respond, whether or not the debtor agrees with the information on the amount
owed in the request. The receipt of a response from the debtor provides evidence of the
authenticity of the receivable and, if the debtor agrees, evidence of the accuracy of the
amount. It provides no positive evidence of collectibility but may detect a disputed amount
which indicates doubtful collectibility. Some auditors request recipients of the confirmation
to provide the balance or invoice amounts owed.
2 Negative form of debtors confirmation The negative form of request asks the debtor to
respond only if there is disagreement with the information given. Generally, the negative form is
considered to provide less reliable evidence, as a non-response may be for reasons other than the
client agreeing with the balance, such as difficulty of reconciling. For this reason the number of
negative confirmation requests sent should be greater than the number of positive requests that
would be sent in similar circumstances. If the number of confirmations returned as undeliv-
erable is more than expected, the auditor may suspect the possibility of fictitious receivables.
A combination of positive and negative forms may be used. For example, where the total
accounts receivable balance comprises a small number of large balances and a large number of
small balances, the auditor may decide to confirm all or a sample of the large balances with positive
confirmation requests, and a sample of the small balances using negative confirmation requests.
AUS 504/ISA 505 states that negative confirmations may be used to reduce audit risk to an
acceptable level when:
1 the assessed levels of inherent and control risk are low;
2 a large number of small balances is involved;
3 a substantial number of errors is not expected; and
4 the auditor has no reason to believe that the confirmation recipients will not seriously consider
the requests.
Exhibit 10.1 (overleaf) shows a positive form. Generally, auditors have found that the response
rate is improved when the request accompanies a regular monthly statement to the customer.
Note that the request comes from the client, and the auditor should ensure that adequate control
over confirmations is maintained.
The confirmation process has to be started early enough during the audit to allow adequate
time to mail initial requests, send second and third requests if necessary, and analyse responses.
When planning the accounts receivable confirmations, the auditor considers the following:
Prior experience Experience with the client or similar clients may have shown poor response
rates or other indications that confirmations are ineffective. Is enough information provided to
help the recipient respond? Is the confirmation being directed to the wrong person?
The nature of the information being confirmed Should invoices or balances be confirmed?
For example, if most of the debtors accounting systems track individual invoices rather than
balances, it is ineffective to send a balance confirmation.
Have there been unusual transactions, such as large sales at or near year-end? The auditor
might design the confirmation to identify inflated sales for the period, such as through invoice-
and-hold transactions, where merchandise is invoiced to customers before delivery.
Is there a medium or high risk of oral agreements, such as lenient rights of return of
merchandise? If so, the confirmation should request information on the terms of agreements.
Respondent Care should be taken to direct the confirmations to the individuals knowledge-
able about the transactions or arrangements.
In evaluating responses the auditor considers whether disagreements noted by debtors merely
indicate discrepancies caused by timing, such as those caused by mailing time for cash receipts or
shipping time for shipments, or are a result of actual clerical errors or disputed amounts. The
auditor does not want to project monetary misstatement for timing discrepancies or isolated
errors, so the qualitative analysis of confirmation responses is extremely important.
Further requests may be sent if an initial positive request does not result in a response. The
reasons for this are: the lack of response may be an indication of fictitious receivables or a bad debt
and these possibilities must be pursued; and the alternative procedures to confirmation are more
costly and time-consuming.
If management requests that the auditor not confirm certain accounts receivable balances,
the auditor should consider whether there are valid grounds for such a request. Such a request
might be justified if, for example, the particular account is in dispute and communication on
behalf of the auditor might jeopardise sensitive negotiations between the entity and the debtor.
Before accepting a refusal as justified, the auditor should examine any available evidence to
support managements explanations, such as correspondence between management and the
debtor. In such cases, alternative procedures should be applied to the accounts receivable not
subjected to confirmation.

E X H I B I T
[Client's Letterhead]
[Date]
[Debtor's Name and Address]
10.1

Format of Dear ..........................,
positive Our auditors, [Name] ................................................, are making an annual audit of
accounts our financial report. Please confirm the balance due at [Date] ........................, which
receivable is shown on our records and the enclosed statement as $ ...................................
confirmation
requests with Please indicate in the space below whether this is in agreement with your records. If
itemised there are differences, please provide any information that will assist our auditors in
statement
reconciling the difference.
enclosed
Please sign and date your response and mail your reply directly to [Auditor's Name
and Address] ....................................................... in the enclosed return envelope.
PLEASE DO NOT MAIL PAYMENTS ON YOUR ACCOUNT TO THE AUDITORS.
Yours sincerely,
...................................................
[Officer's Signature and Title]
....................................................
[Client's Name]
To: [Auditor's Name] ..........................................................................

The balance due [Client's Name] ..................................................... of $............................
as of [Date] ...................................... is correct with the following exceptions (if any):
..................................................................................................................................................
...................................... ...........................................................................................................
Signature ................................................................................................................................
Title: ........................................................................................................................................
Date: ........................................................................................................................................
Alternative procedures to confirmation

As outlined earlier, use of direct confirmations has reduced in practice as auditors have
determined that other procedures are a more appropriate form of audit evidence (in particular as
regards the assertion of valuation). These alternative procedures may include examination of
evidence of subsequent cash receipts, examination of sales and shipping documents and/or oral
confirmation of the balance with the debtor. Generally, subsequent cash receipts are considered
to be a superior form of evidence because sales and dispatch documents originate in the clients
system, and substantiating subsequent collection simultaneously achieves the audit objectives
related to existence and valuation. The alternative procedures are essentially the same: vouching,
tracing and recomputing of source documents as are used in tests of transactions. However,
instead of a representative sample of source documents, the auditor applies procedures to the
specific documents for selected accounts.
These alternative procedures can also be applied to non-respondents to a confirmation
procedure in order to gain sufficient appropriate audit evidence. The auditor also needs to
consider the qualitative characteristics of the non-responses. Is there a systematic characteristic,
such as a tendency to be the year-end transactions?
Materiality
Materiality is used primarily to identify individually significant customer accounts for testing,
either through confirmation or alternative procedures. Examples of customer accounts that might
be identified as individually significant are:
large dollar balances;
significant balances past their due dates;
accounts with unusual names;
related-party balances; and
credit balances.
Often the recorded amount that remains after identifying individually significant items is in
total a very large dollar amount, and audit sampling is necessary (audit sampling procedures are
discussed in Chapter 11). In fact, confirmation of accounts receivable is one of the most frequent
audit sampling applications among direct tests of balances.
Audit risk
The timing and extent of audit procedures is influenced significantly by consideration of audit
risk. The inherent risk factors considered include the nature of products, the nature of distribution
methods, the complexity of the invoicing system and economic developments. The control risk
evaluation focuses on specific control objectives. The extensiveness of procedures to test
collectibility is influenced by environmental considerations, such as changes in national or an
industrys economic conditions, and whether the specific control objective for authorisation and
approval of credit limits and terms for sales transactions was achieved.
Audit efficiency
Efficiencies in testing in the accounts receivable area can be achieved by organising the
documentation of audit procedures around the schedule for the aged trial balance of accounts
receivable. Debtors accounts can be selected from the aged trial balance for further testing. By
footing (adding up) the trial balance and comparing the total to the general ledger and financial
report, the auditor simultaneously establishes the population being sampled and the clerical
accuracy of the trial balance.
1 The major assertions of interest to the auditor in substantive tests of balances for
accounts receivable are existence and valuation.
2 The major assertions of interest to the auditor in substantive tests for the related
transactions of sales and accounts receivable are occurrence and measurement.
Continued

3 The main audit procedures are confirming balances directly with the customers, review
of subsequent receipts and reviewing the aged trial balance of accounts receivable.
4 There are two types of accounts receivable confirmation: the positive form, where the
debtor is asked to respond, whether or not the debtor agrees with the information on
the amount owed in the request; and the negative form, where the debtor is asked to
respond only if there is disagreement with the information given.
learning
objective 5
PURCHASES AND INVENTORIES
Inventories consist of goods to be sold, or used in production of saleable goods, in the ordinary
course of business. The transactions involving inventory are an increase when goods are
purchased, and a decrease when goods are sold. Usually, especially for retail and manufacturing
entities (but not for service entities), inventory is very material and one of the most complex areas
of the audit. The form of inventory varies depending on the nature of the business. A manufacturer
has inventories of raw materials, work-in-process and finished goods. A retailer or wholesaler has
goods acquired for resale. The related transactions cycles are purchases of raw materials
(manufacturer) or finished goods (retailer), and cash payments. This discussion is generalised to
apply to both types of inventory, identifying significant differences at relevant points. Some types
of service industries, such as hospitals or repair services, also have supplies that can be
inventoried, and while in these situations inventories are usually less material, if considered
material the audit approach is generally similar.
Differences from the sales and expenditures

cycles
The inventory area of the audit is sometimes referred to as the production or conversion function,
and there is a relationship between inventory and the sales and expenditures cycles. For example,
for a manufacturer the sales cycle includes the shipment of finished goods and the expenditures
cycle includes the acquisition of raw materials, direct labour (payroll) and overhead expenses.
However, the inventory area is different in nature for reasons explained in the following discussion.
Nature and frequency of accountability tests

Recall that for the sales and expenditures cycles, accountability tests are usually important control
procedures used as a basis for the auditors assessment of control risk. For example, the accounts
receivable subsidiary ledger is reconciled to the general ledger control account, prelists of cash
receipts are reconciled to deposits and accounting postings, and cash in bank accounts is
reconciled to cash accounting records. Also, outside parties may provide information that acts as
a type of accountability test. Monthly statements are mailed to customers and complaints are
independently resolved. Suppliers statements may be reconciled with accounts payable balances.
The accountability tests in the sales and expenditures cycles are usually performed at least
monthly, and some are more frequent. Almost invariably, these tests are control procedures that
are important for achieving specific control objectives that permit the auditor to reduce the
assessed level of control risk.
For inventories, an accountability test is also made, and it is probably the single most important
control procedure in that area. It is the undertaking of a physical inventory count, or stocktake, by
the client. Inventory items are counted and listed, and the results are compared to accounting
records. However, this accountability test usually occurs only once a year, and it is essentially a
stand-alone procedureits effectiveness depends on procedures that are applied only when the
inventory is counted. In practice, there are usually two ways of counting inventory: in a complete
inventory count, operating activity largely stops and all inventory is counted at one time; in a cycle
count, periodic counts of selected inventory items are made during the year, with all items counted
at least once each year. Auditors procedures regarding inventory counts are dual-purpose tests (see
beginning of this chapter), because the auditor is concerned with both the accuracy of the physical
count and the effectiveness of the control procedures over the clients counting and pricing.
Importance of accounting principles

As discussed earlier, audit problems associated with the sales and expenditures cycles tend to be
those related to high-volume clerical processing rather than complex accounting principles.
Accounting principles cannot be totally ignored: for example, the auditor has to be concerned
with classification and recording in the proper period. However, in the inventory area there may
be both a large number of items and complex matters of accounting principle.
Generally, the auditor is concerned with application of accounting principles in the following
respects:
assignment of costs to inventory in accordance with an acceptable accounting method, such
as first-in, first-out (FIFO) or average cost, and the consistency of the accounting method and
the methods of application;
identification and proper accounting treatment of obsolete, slow-moving, excess or defective
inventory items; and
reduction of inventory items to replacement cost or net realisable value (lower of cost or net
realisable value).
It can be very difficult to assign costs to inventory. A manufacturer may use a standard cost
system, and the auditor must be concerned with whether the adjustments to standard cost result
in a reasonable approximation of actual cost. A retailer may use the retail inventory method, and
the auditor must be concerned with whether the adjustment of inventory at selling price
approximates actual cost (or net realisable value if this is lower). For a manufacturer, the allocation
of overhead expenses involves several considerations. No matter what accounting method is used
by a manufacturer, the auditor must be concerned with conformity with regulations on the proper
inclusion of expenses in overhead. For example, if a direct costing method is used, only variable
overhead expenses are assigned to inventory; this method is not in accordance with approved
accounting standards. These standards require the use of absorption costing, where both fixed
and variable production overhead related to bringing inventories to their present location and
condition are allocated to inventory.
The clients costing or pricing of the quantities determined by counting inventory usually
occurs some time after the inventory count to allow for investigation of differences. Generally, this
step, referred to as the pricing and summarisation, is considered to be part of the clients physical
inventory. Under both the complete and cycle count methods, the physical count is reconciled to
perpetual inventory records if they are maintained, with the pricing and summarisation being
based on the reconciled amount.
Materiality and method of allocation

In accounting, the process of apportioning costs incurred between expenses of the current period
and assets that benefit future periods is broadly referred to as allocation. The general accounting
records accumulate the totals of costs incurred for inventory, such as purchases and payrolls.

Source documents provide a record of units purchased (receiving reports) and units sold (shipping
reports), or, as in a perpetual inventory system, a separate record of units may be maintained.
At the end of the accounting period the costs incurred for inventory during the period must be
allocated between units sold and units on hand. This is the function of the cost accounting system.
The term cost accounting system is usually applied to manufacturers. However, even a
merchandiser who acquires goods for resale often needs a system for assigning costs of acquiring
and storing goods, such as freight and warehousing, to inventory. Inventory costs are seldom
confined to the suppliers invoice price.
Cost accounting systems vary greatly in complexity and sophistication. A job order or a process
cost system may concurrently track the internal use and movement of inventory units and costs
and be integrated with the general accounting system. On the other hand, the system may consist
simply of spreadsheets based on general accounting records and unit records that are prepared
periodically or only annually.
Whether the costing approach is sophisticated or rudimentary, the resulting allocation
between the current period and future periods usually has a material effect on profit. Cost of
sales is often 60 per cent or more of sales, the largest expense in the statement of financial
performance. Also, inventory is usually material to the statement of financial position and a
very material component of current assets. Thus, the misstatement of the allocation between
cost of sales and inventory can cause a material misstatement of the operating results and
financial position.
The substantiation of both cost of sales and ending inventory is usually dependent on direct
tests of the ending inventory balance, combined with tests of transactions for the expenditures
cycle or direct tests of balances of accounts related to that cycle. In a continuing engagement,
beginning inventory has been substantiated in the previous period. The amount of cost of sales is,
in effect, a residual of the following activity analysis:
Beginning inventory
Plus Expenditures for goods and services for inventory
Less Ending inventory
Cost of sales
It is usually tested indirectly by tests of inventory and expenditures.

The significance of ending inventory to the determination of net profit, combined with the
high volume of activity and accounting complexities, often creates a high risk of material
misstatement. The inventory area is particularly susceptible to intentional misstatements
designed to manipulate net profit, and it is important for the auditor to maintain professional
scepticism. If the auditors procedures detect discrepancies between accounting records and
supporting documentation or other corroborating information, the auditor should consider the
possibility of material misrepresentations by management.

The essential feature of direct tests of balances for inventories is emphasis on specific audit
objectives related to existence and valuation, achieved primarily by observation of physical
inventory and tests of pricing and summarisation. AUS 506 Existence and Valuation of Inventory
(ISA 501 Audit EvidenceAdditional Considerations for Specific Items: Part A: Attendance at
Physical inventory Counting) establishes standards and provides guidance on obtaining
sufficient appropriate audit evidence regarding these two assertions. The financial report
assertions, specific audit objectives and common audit procedures to achieve these objectives are
summarised in Table 10.4. As applied in the inventory area, these procedures have the following
features:
Observation of physical inventory This term is used to describe the combination of
observation, inquiry and physical examination (test counts) that provides the basis for achieving
several specific audit objectives for inventory. It is explained further in a separate section.
TABLE 10.4 Assertions, objectives and procedures for purchases and inventory

Existence Inventories included in the statement Inspection of physical inventory

of financial position physically exist (checking from inventory records to
and represent items held for sale in physical stock)
the ordinary course of business. Analytical procedures
Confirm stock held at other locations
Occurrence Transactions of purchases and cash Select transactions from purchases

payments occurred during the period. journal and agree to supporting docu-
mentation (e.g. goods received note)
Select transactions from cash payments
journal and agree to supporting
documents (e.g. suppliers invoices)
Completeness Inventory quantities include all items Inspection of physical inventory

on hand or in transit. Inventory listings (checking from physical stock to
are accurately compiled and properly inventory records)
included in the inventory accounts. Analytical procedures
Inquire about stock held at other locations
Rights and The entity has legal title or ownership Check legal ownership of goods being
obligations rights to inventory items, and shipped and goods on consignment
inventories exclude items billed to
customers or owned by others.
Measurement Inventory transactions are recorded Check dollar value of purchases to

in the correct amount and period. inventory price list
Agree dollar value of cash payments to
supporting documents (e.g. suppliers
invoice)
Check last purchases and sales recorded
before balance date and first purchases
recorded after balance date are
recorded in correct period (cut-off)
Test clerical accuracy of inventory listing
Valuation Inventories are properly stated with Tests of pricing and summarisation
respect to: Analytical procedures
cost determined by an acceptable Observation of physical inventory (look
method consistently applied for obsolete or damaged items)
slow-moving, excess, defective, and Inquiry and scanning
obsolete items identified Check subsequent sales prices and com-
reduced to net realisable value if pare with cost
lower than cost.
Disclosure Inventories are properly described and Inquiry and scanning

classified in the statement of financial General procedures
position and related disclosures are
adequate.

Analytical procedures In the inventory area these include computation of ratios for
inventory turnover and detailed gross margin (by product type or code and location) and
comparison to previous periods. For a manufacturer, computation of the ratio of overhead
to materials and labour and comparison to previous periods may be an important
substantive test. If a standard cost system is used, it is usually important to study variance
reports and consider the reasonableness of explanations for variances. Sales forecasts and
marketing plans may provide information relevant to the net realisable value of inventory. In
general, analytical tests usually receive more emphasis in the inventory area than in many
other audit areas.
Cut-off This procedure relates to the measurement assertion and is directed to the control
over shipping and receiving activities at the physical inventory date. Usually, the auditor
identifies the numbers of the last prenumbered shipping and receiving documents at the time
of the observation of physical inventory. These numbers are used for cut-off tests for accounts
receivable and accounts payable recording. The document numbers are also used to
determine whether the related inventory items were properly included or excluded from the
physical inventory count and, if perpetual records are maintained, the inventory records. The
inclusion or exclusion of inventory items in transit should ideally be based on passage of title
as determined by the shipping terms Free on Board (FOB), where title passes at the shipping
point, and Cost, Insurance and Freight (CIF), where title passes at destination. However,
unless the difference would be material, purchases are often recorded when received and
sales when shipped.
Tests of pricing and summarisation This term is used to describe the combination of
vouching, tracing and recomputation procedures used to test the clients pricing and
summarisation of inventory counts. It is explained further in a separate section.
General procedures The general procedures relevant to inventory include reading minutes,
debt instruments and agreements to find indications of liens or pledging of inventory,
unrealised losses on purchase commitments or inventories held on consignment.
Inquiry and scanning The important inquiries for inventory include discussion with
management concerning obsolete, excess or slow-moving inventory, and the same matters as
described above for general procedures. Scanning includes reviewing perpetual records or
other records or reports of inventory usage and movement in order to identify any such
obsolete, excess or slow-moving items.
Observation of the physical inventory

The following list highlights points that are often misunderstood about observation of physical
inventory:
1 The clients taking of the physical inventory is a control procedure, but it is a stand-alone
activity and its effectiveness is not dependent on control over processing transactions.
2 The procedures the auditor uses are a combination of observation, inquiry and physical
examination (making test counts of clients counts).
3 The auditors goal is to obtain reasonable assurance that the clients methods of counting
inventory result in an accurate count, which is a test of controls. The auditor undertakes test
counts as an aid in making this assessment, rather than attempting to directly substantiate
inventory quantities by counting.
4 In most circumstances there are no satisfactory alternative procedures to making or observing
some counts of items in inventory for verifying the ending inventory.
When inventory is material, the auditor is required to obtain sufficient appropriate audit
evidence regarding its existence and condition by attendance at a physical inventory count unless
it is impractical (AUS 506/ISA 501). In exceptional circumstances, the auditor may judge it
necessary to depart from this procedure in order to achieve the same objective more effectively;
the justification for this departure should be documented in the audit working papers.
In planning attendance at the physical inventory count, the auditor considers the following
matters:
inherent, control and detection risks and materiality related to inventory;
whether adequate procedures are expected to be established and proper instructions issued
for physical inventory counting;
the timing of the count;
the locations at which inventory is held; and
whether an experts assistance is needed.
In determining the need to use an expert, the auditor would consider the materiality of the
inventory, the nature and complexity of the items and other evidence that is available. Situations
in which experts are normally required include where minerals are stored in stockpiles or where
the client is in the business of selling items such as gems or paintings that require expert valuation.
If an expert is required, the auditor follows the standards and guidance outlined in AUS 606/ISA
620 Using the Work of an Expert, as discussed in Chapter 5.
The desirable features of client procedures for taking a physical inventory include the
following:
a written plan of instructions for inventory counting which is communicated to all relevant
staff;
proper arrangement of inventory items to facilitate counting;
procedures for the identification and recording of obsolete or excess inventory;
numerical control of inventory tags or count sheets and accounting for all used and unused
tags or sheets;
personnel on inventory count teams who are independent of inventory storekeeping; and
supervision of counting by internal auditors or supervisory personnel who re-count on a test
basis.
To obtain assurance that managements procedures are adequately implemented, the auditor
observes employees procedures and performs test counts. When performing counts the auditor
may test both the completeness and the existence of inventory by tracing items selected from
those records to the physical inventory, and items selected from the physical inventory to the
count records. The auditor considers the extent to which copies of such count records need to be
retained for subsequent testing and comparison. The auditor also considers cut-off procedures,
including details of the movement of inventory just before, during and after the count, so that the
accounting for such movements can be checked at a later date.
A physical inventory count conducted at a date other than period end is usually adequate for
audit purposes only when control risk is assessed as less than high. The auditor assesses whether,
through the performance of appropriate procedures, changes in inventory between the count date
and period end are correctly recorded. When the entity operates a perpetual inventory system
which is used to determine the period-end balance, the auditor would assess, through the
performance of additional procedures, whether the reasons for any significant differences
between the physical count and the perpetual inventory records are understood, and whether the
records are properly adjusted.

Sometimes the inventory balance may be material, but attendance at an inventory count is
impractical because of the nature or location of the inventory, or in exceptional circumstances the
auditor is able to justify not attending the physical inventory counting (e.g. counting cattle that are
roaming around a Northern Territory cattle ranch). In these circumstances the auditor should
consider whether alternative procedures provide sufficient appropriate audit evidence of
existence and condition to conclude that they need not make reference to a scope limitation in the
audit report (refer to Chapter 13). For example, the auditor may not be engaged until after the
clients physical inventory. A satisfactory alternative procedure is for the auditor to make test
counts at a later date and, by examining the documentation of inventory receipts, issues,
movements and shipments, to work back to the quantities on hand at the count date and make
comparisons to the clients counts. This means the client must maintain either good perpetual
records or other sufficient documentation of inventory movements to permit the equivalent of
perpetual records to be prepared for the period between the count date and the auditors test
counts. The auditor reviews client documentation of counts and counting methods.
In order to test the completeness assertion for inventory, the auditor needs to make inquiries
about stock held at locations other than the clients. Incomplete inventory records may be detected
using analytical procedures such as the ratio of sales to cost of sales to discover irregularities.
If inventory is under the custody and control of a third party, the auditor ordinarily obtains
direct confirmation from the third party as to the quantities and condition of inventory held on
behalf of the entity. Depending on the materiality of this inventory the auditor would also:
consider any apparent lack of integrity and independence of the third party;
observe, or arrange for another auditor to observe, the physical inventory count;
obtain another auditors report on the adequacy of the third partys internal control structure
for ensuring that inventory is correctly counted and adequately safeguarded; and
inspect documentation regarding inventory held by third parties, for example warehouse
receipts, or obtain confirmation from other parties when such inventory has been pledged as
collateral.
Tests of pricing and summarisation

The auditors tests of pricing and summarisation are a combination of vouching, tracing and
recomputation to test the following aspects of the clients procedures:
summarisation of quantities from the count tags or sheets to the inventory list;
application of prices to the quantities in the list;
computation of the extensions and footings of the list; and
identification of obsolete, excess or slow-moving items and reduction of their prices to net
realisable value where this is lower than cost.
The auditors procedures for testing the summarisation of quantities are designed to provide
reasonable assurance that all items counted are included in the listing (giving evidence that the
listing is complete), and that no items have been inappropriately added (giving evidence that all
inventory items on the list exist). Therefore, the auditor is concerned with both existence and
completeness. The auditor reviews the listing to see that only tags or sheets used for the clients
counts are included, and compares selected items on the list to the record of the auditors test
counts and to the clients tags or sheets.
The auditor is required to evaluate the bases used by management in the valuation of
inventory and to perform audit procedures designed to obtain sufficient appropriate audit
evidence regarding these bases. Audit sampling may be used, and the extent of testing may be
restricted when the control risk for the purchases subsystem is evaluated as less than high.
The extent of testing for obsolete, excess or slow-moving items depends on the care and
thoroughness of the clients own review for such items. If the entity has adopted specific criteria,
such as a reduction in cost for all items for which they have over a years supply on hand and all
items that have not been sold or used within six months, the auditor evaluates the reasonableness
of the criteria and tests the clients application. The auditor may also vouch unit prices to
suppliers invoices, open purchase orders, current supplier price lists or published prices and
review records of internal usage and movement of inventory.
Materiality
The auditor uses materiality in the inventory area primarily as a means of identifying individually
significant inventory items and regards items as individually significant because of their dollar
size. The auditor usually includes these items among the items test counted and determines the
number of test counts to make on the basis of risk and materiality considerations. The risk and
materiality considerations will be influenced by whether the physical arrangement of items
facilitates observation and accurate counting, and the extent of the clients planning, supervision
and testing of the counts.
Audit risk
The extent of the auditors coverage of the clients physical inventory is based largely on the review
of the clients plans and arrangements and past experience. Many clients will have their inventory
stocktake on or near to balance date. However, there will be others who will undertake the
stocktake at an interim date.
Consideration of audit risk is a very important factor in deciding whether the observation of
physical inventory can be made at the earlier date. The specific control objectives that are relevant
to this consideration include those for recording accuracy for purchases, sales and cost
accounting and safeguarding controls over inventory. Important controls for inventory are:
for storage areas to be secured against unauthorised admission by protective measures such as
guards, alarm systems, fences or locked areas, and admission by an identification badge or
pass;
inspection of all materials leaving the premises for authorised shipping documents; and
use of prenumbered documents, with the sequence accounted for independently, for
receiving, materials requisitions, production orders and shipping.
The auditor needs reasonable assurance that the relevant control procedures continue to
function in the period between the date of the observation and the balance date. This means the
auditor has to test the control procedures related to safeguarding around the balance date. If
controls over recording accuracy for purchases, sales and cost accounting are functioning
satisfactorily at an interim date, the auditors understanding of these control procedures may also
be updated by inquiry and observation. If there are deficiencies in these controls but safeguarding
procedures are adequate, the auditor may be able to test transactions during the intervening
period so as to enable the auditor to extend the conclusion based on the interim observation to
the balance date. If there are serious deficiencies in safeguarding controls, or if the auditor
believes there is a serious risk of management misrepresentations, then the observation of the
physical inventory must be performed at or near the balance date.

1 Due to the significance of inventory to the determination of net profit, and the
associated high levels of activity and accounting complexities, inventory is often one of
the most complex and high-risk areas to audit.
2 The main assertions of interest to the auditor in undertaking tests of balances for
inventory are existence and valuation.
3 The main audit procedures are observation of physical inventory and tests of pricing and
summarisation.
4 When inventory is material the auditor is required to attend a physical inventory count
unless impractical. To obtain assurance that managements procedures for the inventory
count are adequately implemented the auditor observes employees procedures and
performs test counts.
5 The auditor tests the summarisation of quantities from the inventory count to obtain
reasonable assurance that all items counted are included in the inventory list, and that
no items have been inappropriately added.
6 The auditor tests valuation by vouching items to suppliers invoices and cost accounting
records, and examines the clients review of obsolete, excess and slow-moving items.
learning
objective 6
ACCOUNTS PAYABLE AND PAYMENTS
A major part of accounts payable is trade creditors, which is related to the purchases/inventory/
cash payments cycle. When shipments of raw materials and finished goods are received and
placed in inventory, this gives rise to an equivalent liability, trade creditors, until payment is made.
Accounts payable is also comprised of other suppliers (such as suppliers of electricity or other
items not used in production or resale), also sometimes termed other creditors. The essential
feature of direct tests of balances for accounts payable is emphasis on the specific audit objective
related to completeness. This is a reflection of the fact that the auditors major risk is in
understatement of this account. For example, a major risk is that inventory is received and
included as an asset, but the equivalent liability is not immediately taken up. The completeness
objective is achieved primarily by a search for unrecorded accounts payable and analytical tests of
related expense account balances.

The financial report assertions, specific audit objectives and the common audit procedures
traditionally used to achieve the objectives for accounts payable and related accounts are
summarised in Table 10.5. As applied in the accounts payable area, these procedures have the
following features:
Confirmation Confirmation procedures for accounts payable balances are less common in
practice compared with confirmation of accounts receivable. Confirmation is generally
considered relevant to achieving specific audit objectives related to existence, rights and
obligations and to some extent valuation, and can be an efficient and effective procedure for
achieving these specific audit objectives. However, some auditors use confirmation
procedures for accounts payable balances when control objectives related to occurrence and
measurement of associated transactions have serious deficiencies. Confirmation requests are
sent to suppliers with whom the entity has done a relatively large volume of business during
the period. The auditor is concerned with what should be recorded rather than what is
recorded, so the emphasis is placed on selecting suppliers who are likely to have large
balances. The accounts payable balances selected may therefore include zero and small
recorded balances. The normal form of confirmation request for payables is positive and asks
the supplier to state the balance due from the client. The auditors analysis of responses is
similar to that for confirmation of receivables. A distinction must be made between
discrepancies caused by payments and shipments in transit, such as a cheque drawn before
year-end which the supplier doesnt receive until after year-end, and those caused by clerical
errors, disputes and unrecorded invoices.
TABLE 10.5 Assertions, objectives and procedures for accounts payable and related
accounts

Existence Accounts payable and accrued Confirmation

liabilities are valid obligations to Vouching
suppliers at the balance date.
Completeness Accounts payable and accrued liabil- Out-of-period liability search

ities include all obligations owed to General procedures
suppliers at the balance date.
Occurrence Transactions giving rise to accounts Select transactions from accounts

payable occurred during period. payable listing and agree to supporting
documentation (e.g. suppliers invoices)
Rights and Accounts payable and accrued Confirmation

obligations liabilities are obligations owed by General procedures
the entity.
Measurement Accounts payable are recorded Cut-off

in the correct amount and period. Check clerical accuracy of accounts
payable listing
Agree dollar value of accounts payable
to supporting documents (e.g. suppliers
invoices)
Valuation Accounts payable and accrued Recomputation

liabilities are presented at the Analytical procedures
appropriate amount.
Disclosure Accounts payable and accrued Inquiry and scanning

liabilities are properly described General procedures
and classified in the statement of
financial position and related
Vouching Some auditors regard vouching recorded payables balances to suppliers statements
as equivalent in reliability to confirmation because the evidence originates outside the clients
accounting system. Vouching is effective when recorded accounts payable are reconciled to
monthly statements received from suppliers. However, if the clients system does not include
an accounts payable subsidiary ledger or suppliers master file, such a reconciliation can be
time-consuming and difficult.
Search for unrecorded liabilities The emphasis with this procedure is on identifying
obligations that should have been recorded at the balance date. It directly tests the accounts
payable balance for understatement and because it is the central procedure in the accounts
payable area it is explained further in a separate section (below).

General procedures The search for unrecorded liabilities focuses on detecting unrecorded
accounts payable or accrued liabilities for goods or services received at the balance date.
However, other unrecorded liabilities may arise from matters such as commitments under
contracts, legal claims against the entity or other loss contingencies. The auditor normally
relies on general procedures, such as reading minutes, contracts, loan agreements, leases and
correspondence from government agencies, to detect unrecorded liabilities for which no
indication exists in the accounting records or source documents. For example, the minutes of
meetings of the board of directors may reveal an unrecorded dividend payable or a potential
legal liability.
Cut-off The auditor determines the last receiving report, last voucher and last payment of the
current period by reference to the prenumbered sequence for those documents, and then
checks that the transactions immediately before and after cut-off are recorded in the correct
period.
Analytical procedures Comparison of expenses, budgets and level of activity in the current
period with similar information from previous periods can provide evidence for recorded
expense and liability balances. In some cases an analytical test can substantiate the total
expense and related accrued liability. For example, sales commission expense and accrued
commissions payable can usually be reliably estimated based on recorded sales and
knowledge of the terms for commissions.
Recomputation Some accrued liabilities, such as electricity and telephone accounts, can be
substantiated by examining payments in the subsequent period and calculating the portion
attributable to the previous period under audit. In general, recomputation is used for accruals
and deferrals that are recurring adjustments in closing the accounting records.
Inquiry and scanning The auditor uses inquiry and scanning in conjunction with other
general procedures to identify matters relevant to the description, classification and related
disclosure of liabilities in the statement of financial position. For example, inquiry and
scanning may identify related-party payables or losses under sales or purchase commitments.
Search for unrecorded liabilities

This procedure is also sometimes called the out-of-period liability search or the review of
subsequent payments. This audit procedure is invariably included in audit programs for direct
tests of the accounts payable balance.
The potential for unrecorded liabilities arises from both errors and irregularities. Errors result
because of practical problems in closing the accounting records. Invariably some goods or
services received before the end of the period do not become known and recorded until the next
period. Controls over suppliers invoices and receiving reports, matching of these source
documents and investigation of unmatched items can minimise this problem. The auditors
objective is to obtain reasonable assurance that material liabilities have not been omitted.
Intentional omission of liabilities that exist at balance date does not change the auditors
objective. In fact, the same audit procedures should detect material omissions whether they are
inadvertent or intentional. Goods or services received will ultimately have to be paid for in the
next period to avoid disputes with suppliers, loss of credit lines or litigation with creditors.
The auditor selects from cash payments recorded in the subsequent period and traces them to
the schedule of accounts payable outstanding at balance date, identifying those payments that
pertain to the period under audit. Those identified payments not included in the schedule are
unrecorded liabilities. The auditor also reviews and selects from unmatched receiving reports and
suppliers invoices received by balance date and suppliers invoices received in the subsequent
period in order to detect liabilities that should have been recognised at balance date.
Any suppliers invoices representing unrecorded liabilities at balance date that are not received
or paid before the auditor applies these procedures would not be detected. Thus, effectiveness is
improved by doing the search for unrecorded liabilities relatively late in the audit. Confirmation of
accounts payable balances is not subject to this disadvantage. It can therefore be an important
complement to the search for unrecorded liabilities, particularly when the audit is scheduled for
completion relatively close to balance date.
Materiality
In the search for unrecorded liabilities, materiality is used primarily to identify the items to be
selected. In other words the auditor selects all cash payments, suppliers invoices or receiving
reports from the relevant period that exceed a cut-off amount. Since all items above the threshold
amount are selected, audit sampling is not being used.
Audit risk
The inherent risk factors the auditor considers include the number of principal suppliers, supplier
billing practices, the clients purchasing methods and the principal types of goods or services
purchased. Also, organisational considerations such as managements attitude to control and factors
that predispose management to make material misrepresentations are particularly important.
Control risk generally focuses on specific control objectives related to completeness and
reconciliation. Considerations that are particularly important in determining the extent of the
out-of-period liability search are the effectiveness of:
the clients review and investigation of unmatched prenumbered purchase orders and
receiving reports at the end of the period;
the clients reconciliation of suppliers statements with accounts payable balances; and
the clients monthly reconciliation of the schedule of accounts payable with the general ledger
accounts payable balance.
Audit efficiency
Some audit efficiencies are possible in the accounts payable area. For example, because selection of
suppliers for confirmation is based on the expected volume of purchases rather than the amount of
the recorded balance, the confirmation requests can be sent before the accounts payable trial
balance is prepared or tested. Also, sending the confirmation requests on or around the balance date
allows the supplier to respond directly to the auditor with information they have gathered through
their normal billing process. However, the primary efficiency consideration is co-ordination of the
out-of-period liability search and confirmation of payable balances in order to avoid duplication of
audit procedures to achieve specific audit objectives related to completeness and valuation.
1 The main assertion of interest to the auditor when undertaking tests of balances of
accounts payable is completeness.
2 The main audit procedures are a search for unrecorded accounts payable, confirmations
and analytical procedures on related expense account balances.

learning
objective 7
NON-CURRENT ASSETS
The audit approaches for each of the account balances in this broad category are generally similar.
The account balances are usually affected by a few large transactions, and amounts from previous
periods have continuing significance; that is, the account does not turn over frequently. Thus, the
approach to the direct tests of balances for account balances in this category is to directly test the
transactions that affected the account during the period; this indirectly substantiates the ending
balance. The related revenue and expense accounts are normally examined in conjunction with
the statement of financial position accounts. For example, depreciation expense is tested in
conjunction with property, plant and equipment.
Property, plant and equipment

The asset category of property, plant and equipment generally includes land, buildings and manu-
facturing equipment. It may also include office equipment, furniture and fixtures and even when
these assets are classified separately the audit approach is generally the same as for property, plant
and equipment.
The essential feature of direct tests of balances for property, plant and equipment is emphasis
on specific audit objectives related to existence, rights and obligations and valuation, achieved
primarily by substantiating additions and identifying retirements during the period, considering
any revaluations undertaken during the year and analytically testing or recomputing related
expense and allowance accounts. The occurrence of the transactions associated with purchases of
property, plant and equipment is covered by verifying the existence of the additions to property,
plant and equipment as listed at balance date.

Table 10.6 summarises the financial report assertions, the specific audit objectives and the
common audit procedures traditionally used to achieve the objectives for property, plant and
equipment and related account balances. As applied in the property, plant and equipment area,
these procedures have the following features:
Vouching This procedure consists of inspecting the supporting documentation for additions,
retirements and changes in valuation during the period. For example, the auditor examines the
suppliers invoice and the receiving report for new equipment, and considers the
appropriateness of capitalisation in light of entity policy and accounting principles. If assets
are revalued, the new values may need to be sourced back to supporting documentation such
as an independent experts opinion.
Physical examination The auditor obtains knowledge of additions and retirements through
inquiries to client personnel, reviewing accounting records and touring the plant. The auditor
notes whether any identified new equipment is entered in the accounting records and whether
items in the accounting records can be located in the plant.
Analytical procedures Several analytical procedures are useful for detecting misclassified addi-
tions, unrecorded retirements and miscalculation of depreciation expense. The auditor compares
property, plant and equipment balances and depreciation expense with amounts of previous years
and budgets, and current additions to the capital budget. Also, the auditor computes the ratio of
depreciation expense and accumulated depreciation to equipment balances in the current and
previous periods. The auditor also relates changes in property, plant and equipment balances to
expected related changes in insurance expense, land taxes and repairs and maintenance expense.
TABLE 10.6 Assertions, objectives and procedures for property, plant and
equipment

Existence Property, plant and equipment Vouching to invoices

included in the statement of Physical examination of additions
financial position physically exists. Analytical procedures
Retirements are removed.
Completeness Property, plant and equipment Inquiry

includes all capitalisable costs Scanning repairs and maintenance for
(capitalisable costs are not expensed). items that were expensed rather than
capitalised
Rights and The entity has legal title or equivalent General procedures
obligations ownership rights to property, plant Inquiry scanning
and equipment included in the
statement of financial position and
the related lease obligation of
capitalised leased assets is recognised.
Measurement Property, plant and equipment is Test clerical accuracy of property, plant
recorded at its appropriate carry value. and equipment listing
Cut-off is not an issue because there
is not a continuous flow of
transactions relating to this account.
The tests as to whether the recording
takes place in the correct period are
usually under existence or
completeness.
Valuation Property, plant and equipment are Recomputation

appropriately valued and allowances Analytical procedures
for depreciation or depletion are Vouching costs to invoices
computed on the basis of acceptable Inquiries about revaluations
and consistent methods. Additions
include only the capitalisable cost of
assets purchased, constructed or leased.
Disclosure Property, plant and equipment is General procedures

properly described and classified in Inquiry and scanning
the statement of financial position,
and related disclosures are adequate.
Inquiry and scanning The auditor asks operating management and personnel about actual
additions and retirements. Inquiries to executive management may reveal where revaluations
have taken place. The auditor also asks about decisions, such as adding or discontinuing a
product or a line of business or revaluing a class of assets, that affect additions and retirements
or an asset valuation. A scan of the accounting records for miscellaneous revenue resulting
from the sale of retired equipment may be undertaken in circumstances where the auditor
considers that this amount may be potentially material.
Recomputation The auditor recomputes depreciation expense and considers whether
depreciation is calculated in accordance with an acceptable accounting method consistently
applied. Usually, the auditor does not need to make a detailed recomputation when
depreciable assets are voluminous. Depreciable assets may be grouped in categories with

similar lives and the same depreciation method, and the calculation made on an overall basis.
Technically, this is an analytical procedure.
General procedures The general procedures relevant to property, plant and equipment
include reading minutes, inspecting debt agreements and making inquiries to management in
order to identify significant changes in the composition or valuation of property, plant and
equipment and related liens and mortgages requiring disclosure.
Substantiation of additions
The auditor uses a combination of vouching (inspecting supporting documentation), physical
examination (touring the plant) and analytical procedures to substantiate additions to property,
plant and equipment. The vouching includes both additions recorded in property, plant and
equipment accounts and items recorded in the repairs and maintenance expense account. In
reviewing the charges to repairs and maintenance expense, the auditor is concerned with the
specific audit objective related to completeness for property, plant and equipment. Repairs and
maintenance expense may contain costs that should be capitalised rather than expensed. Whether
the item is capitalised or expensed depends on conformity with approved accounting standards
and adherence to entity policy.
Identifying retirements
In achieving the specific audit objective related to existence for property, plant and equipment,
the auditor is concerned with detecting significant unrecorded retirements. Generally, the auditor
uses a combination of vouching, physical examination and analytical procedures to identify them.
When vouching additions the auditor notes whether the item is new or a replacement, and traces
the replacements to the recording of a retirement. The auditor observes whether or not significant
recorded items are in the plant. A study of relationships between related accounts, such as property
insurance, land taxes and miscellaneous revenue, may also disclose unrecorded retirements. For
example, sale of retired equipment as scrap may be recorded as miscellaneous income. Also, the
auditors knowledge of the business can be an important factor in identifying unrecorded
retirements. For example, the auditors knowledge of the discontinuance of a particular product,
combined with knowledge that certain equipment is used exclusively for making that product, lead
the auditor to expect to see a recorded retirement or reclassification for that equipment.
Valuation of property, plant and equipment

The auditor must be satisfied that the carrying value of property, plant and equipment does not
exceed the amount it would have been reasonable for the business to spend to acquire the asset
at the end of the accounting period on a going-concern basis. In addition, accounting standard
AASB 1010 Recoverable Amount of Non-Current Assets requires that the revaluation of a class of
non-current assets should not result in the net value of any asset in that class exceeding the
recoverable amount.
There are three principal ways of finding evidence of overvalued assets: observing obsolete or
damaged units during a tour of the plant; identifying assets associated with discontinued activities
but not yet disposed of; and inquiry of management as to budgets and forecasts in relation to the
carrying value of assets.
Management sometimes chooses to revalue property, plant or equipment assets upwards so as
to reflect their value to the business more fairly. AASB 1041 Revaluation of Non-Current Assets
requires that any upward revaluation must be applied to a class of assets and not to individual
assets within a class. Assets are required to be stated to their fair value. AUS 526/ISA 545 Auditing
Fair Value Measurements and Disclosures outlines that substantive tests may involve:
testing managements significant assumptions, the value model, and the underlying data
(paragraphs .39.49) and
developing independent fair estimates to corroborate the appropriateness of the fair value
measurement.
If the valuation is undertaken by an independent expert the auditor needs to be satisfied as to their
skill, competence and objectivity. The auditor vouches the valuers report, paying regard to the
basis of valuation, and considers its appropriateness as a basis for determining the carrying
amount of that class of assets in the financial report. Major revaluations should be discussed by
the board of directors or audit committee, and the auditor should review minutes of such
discussions. If classes of assets are revalued, the auditor must ensure that there is adequate
disclosure, including the basis of revaluation and, if an independent valuer was used, the name
and qualifications of this person.
If, after considering the available evidence, there is still a risk of a material misstatement, the
auditor may consider getting an independent expert valuation. In such a situation the auditor
needs to follow the standards and guidance outlined in AUS 606/ISA 620 Using the Work of an
Expert, discussed in Chapter 5.
Materiality and audit risk

The usual approach to substantiating additions is to vouch all those above a specified cut-off
dollar amount. In the property, plant and equipment area, account balances are relatively more
susceptible to misstatement caused by misapplication of accounting principles. The accounting
principles for determining the proper costs to include in acquisition cost and the proper
accounting treatment of significant repairs, improvements and similar matters are relatively
complex. Also, the accounting standard related to capitalisation of leased assets (AASB 1008/
IAS 17 Accounting for Leases) is relatively complex, increasing the associated risk.
The auditors assessment of control risk is also influenced by the results of tests of transactions
for the expenditures cycle. The auditor might incorporate this assessment into the direct tests of
balances for property, plant and equipment by adjusting the cut-off amount for additions to be
vouched. Other factors the auditor considers in assessing the likelihood of material misstatement
in property, plant and equipment include whether the clients procedures contain the following
measures to reduce control risk:
use of capital budgeting for acquisition of property, plant and equipment, with careful
monitoring and follow-up;
detailed property, plant and equipment ledgers maintained and periodically reconciled to
general ledger control accounts;
identification tags fixed to new property, plant and equipment and issued tags reconciled to
detailed property, plant and equipment ledger; and
formal policy for capitalisation/expense decisions, partial depreciation and procedures for
reporting of retirements established and incorporated in procedures manuals.
Normally, entities do not make an annual physical inspection of property, plant and
equipment comparable to a physical inventory count. Such inspections may be made every three
to five years. The auditor normally does not insist on observing a physical inspection of property,
plant and equipment unless there are very serious deficiencies in controls.

1 The main assertions of interest to the auditor when undertaking tests of balances for
property, plant and equipment are existence/occurrence, rights and obligations, and
valuation.
2 The main audit procedures for property, plant and equipment are substantiating
additions and identifying retirements during the period, checking supporting
documentation for changes in valuation and establishing analytical procedures for
related expense and allowance accounts.
Investments and intangible assets

The audit approach and the audit problems for investments and intangibles are similar to those
for property, plant and equipment. The auditor focuses on directly testing the transactions that
affect the balances during the period, and conformity with approved accounting standards is very
important. However, investments in the ending balance are normally substantiated directly.
Investments
The form of investments can vary considerably. Investments may be in debt or equity securities;
the securities may be marketable or non-marketable; the entities whose securities are held may be
associated or non-associated. Also, an investment may be a loan or advance rather than a security.
This discussion focuses on long-term investments. However, the primary distinction between
long-term investments and investments classified as current assets is managements intention
and ability to hold the investment for longer than one year. Thus, the discussion generally applies
to most investments.
The financial report assertions, specific audit objectives and common audit procedures
traditionally used to achieve the objectives for investments are summarised in Table 10.7. The
essential features of direct tests of balances for long-term investments are emphasis on specific
audit objectives related to existence and rights and obligations, achieved primarily by physical
examination or confirmation and vouching; and emphasis on specific audit objectives related to
valuation, achieved by a combination of recomputation, vouching and tracing or other
specialised procedures. The occurrence of the transactions associated with investments is covered
by verifying the existence of the investments at balance date.
If the investment has a physical existence and is in the clients possession, such as debt
instruments that were purchased, physical examination is appropriate. If the investment has no
physical existence, such as a loan or advance, or is held in safekeeping by an independent
custodian, then the auditor should examine any documentary evidence such as a loan agreement
and also consider sending a confirmation request to the investment custodian.
The difficult accounting and auditing issues in the long-term investment area usually relate to
specific audit objectives concerned with valuation. Generally, the relevant auditing procedures are
determined largely by the method of valuation that is most appropriate under the accounting
standards.
Whether investments in securities are carried at cost or at market value depends on their
nature and classification. Cost is substantiated by vouching the acquisition price in the
accounting records, and market price is substantiated by comparing with published market
quotations.
TABLE 10.7 Assertions, objectives and procedures for investments
Existence Investments in securities (shares, Physical examination

bonds, notes) physically exist and Confirmation
loans and advances exist.
Completeness All investments are included in the General procedures

statement of financial position.
Rights and The entity owns or has ownership Vouching

obligations rights to all investments included Physical examination
in the statement of financial position. Confirmation
Measurement Investments are recorded in the correct Test clerical accuracy of listing of
amount. Cut-off is not usually a major investments
issue because there is not a continuous
flow of transactions relating to this
account. Tests as to whether the
recording takes place in the correct
period are usually included under
existence and completeness.
Valuation Investments are valued properly Recomputation, vouching and tracing

with respect to the accounting Inspection of market quotations or
standards. financial statements
Disclosure Investments are properly described General procedures

and classified in the statement of Inquiry and scanning
financial position and related
The direct tests of balances for investments also include tests of the related investment income
and of gains or losses in investment transactions. By reference to the financial press, the auditor
can substantiate dividend and interest income on investments and the trading price at the time of
purchase or sale of securities.
Intangible assets
A variety of items fall into this asset category: patents, copyrights, intellectual property,
organisational costs, franchise fees and goodwill acquired in a business combination. The
essential feature of direct tests of balances for intangibles is emphasis on specific audit objectives
related to existence and valuation, achieved primarily by vouching, inspection of legal documents
and recomputation or analytical procedures. The primary risk of misstatement arises from
misapplication of principles set out in approved accounting standards.
The accounting issues generally relate to whether or not a cost may properly be deferred and
the appropriate amortisation period. For example, research and development costs must be
accounted for in accordance with AASB 1011 (IAS 38) Accounting for Research and Development.
There are difficulties in identifying research and development costs and the recoverable amount,
with capitalisation required where costs are expected beyond any reasonable doubt to be
recoverable, and amortisation required in order to match such costs with related benefits.
For purchased goodwill, guidance and standards are provided by AASB 1013/IAS 22 Account-
ing for Goodwill. Again the difficult tasks are measuring goodwill and determining an appropriate
method of amortisation.

investments are existence, rights and obligations, valuation and disclosure.
2 The main audit procedures for the verification of existence and rights and obligations of
investments are physical examination or confirmation and vouching. Evidence for
valuation may be gained by recomputation, vouching and tracing or other specialised
procedures. Evidence for disclosure requires an assessment of the form of the investment
and managements intention and ability to hold the investment for longer than one year.
intangibles are existence and valuation.
4 The main audit procedures for intangible assets are vouching, inspection of legal
documents and recomputation or analytical procedures.
learning
objective 8
NON-CURRENT LIABILITIES AND OWNERS EQUITY
Non-current liabilities
Generally, non-current liabilities include loans, bonds, and notes payable that are due after one year
from the balance date. The current portions of otherwise long-term obligations are classified as cur-
rent liabilities, but are examined in conjunction with non-current liabilities. Also, interest expense
and other related account balances are examined in conjunction with non-current liabilities.
The essential feature of direct tests of balances for non-current liabilities is the emphasis on
the specific audit assertion of completeness, achieved primarily by confirmations, general proce-
dures and analytical procedures.

The financial report assertions, specific audit objectives and common audit procedures that are
traditionally used to achieve those objectives for non-current liabilities are summarised in Table
10.8. As applied to non-current liabilities, these procedures have the following features:
Confirmation Normally, the auditor confirms the balance and related details, such as security
held, interest rate and terms and interest paid and accrued, directly with all significant debt
holders. The form of confirmation is similar to that which is used for accounts payable. Where a
trustee keeps the detailed records of debt holders and makes interest payments to them, the
confirmation request is sent to the trustee. The standard bank confirmation form can be used for
banks that are holders of debt. Details of compensating balances, lines of credit and contingent
liabilities are also separately confirmed with the bank. Care should be taken to achieve the
specific audit objectives related to completeness as well as those related to existence.
General procedures For non-current liabilities, general procedures contribute more directly to
the achievement of audit objectives than is often the case in other areas. The most important
general procedures are reading minutes of meetings of the board of directors and reviewing
debt agreements. The auditor is concerned with ascertaining that all obligations are authorised
by the board of directors. Debt agreements are extremely important because violation of the
terms may result in automatic acceleration of the due date on which the debt has to be repaid.
When the debt is reclassified as current, this may materially affect the entitys financial position
and its ability to meet its obligations on a timely basis. Debt agreements often contain
provisions requiring maintenance of specified working capital and debt to equity ratios and
restricting the payment of dividends or other financing activities. Also, the debt may be secured
by either specific or floating charges over assets of the entity. The auditor must also consider the
possibility of the entity being placed in liquidation through violation of debt covenants.
Analytical procedures Analytical procedures for non-current liabilities include comparison of
balances with the previous period, and comparison of new debt proceeds and principal repay-
ments with cash flow projections. Also, the auditor considers the reasonableness of the entitys
average interest rate incurred (interest expense divided by the average of the beginning and
ending debt balances). An unreasonably high average interest rate incurred might indicate
unrecorded debt.
Inquiry The classification of debt as current or non-current may depend on the intent and
ability of management to refinance obligations. The auditor substantiates this ability by
examining evidence of actual refinancing in the subsequent period or the non-cancellability of
financing agreements. The auditor also makes inquiries of management to corroborate intent.
Some obligations, such as obligations that arise when a decision is made to dispose of a
segment of a business, are recognised before a liability is legally incurred, and it is important
to ask management about such obligations.
Recomputation, vouching and tracing The auditor tests interest expense by recomputing the
amount based on the outstanding balance, interest rate and fraction of the year outstanding,
with these details being agreed to loan documentation. Interest payments are vouched to cash
payments records, and the proceeds of new issues are traced to cash receipts records. The
volume of debt transactions is generally low and all items are tested. If volume is high,
analytical procedures may be used.
TABLE 10.8 Assertions, objectives and procedures for non-current liabilities

Existence Debt and similar obligations in the Confirmation of identified liabilities

statement of financial position exist General procedures
at the balance date.
Completeness The statement of financial position General procedures

includes all debt and similar obligations Analytical procedures
incurred at the balance date.
Rights and Debt and similar obligations are legal General procedures
obligations or specific and definite obligations of Inquiry
the entity.
Measurement Non-current liabilities are recorded in Test clerical accuracy of listing of non-
the correct amount. Cut-off is not current liabilities
usually a major issue because there is
not a continuous flow of transactions
relating to this account. Tests as to
whether the recording takes place in
the correct period are usually included
under existence and completeness.
Valuation Debt and similar obligations are Recomputation, vouching and tracing
presented at the proper amounts.
Disclosure Debt and similar obligations are General procedures

properly described and classified and Inquiry
related disclosures are adequate.

Materiality and audit risk
For non-current liabilities, consideration of materiality is not usually a significant factor in the
nature, timing and extent of tests. There are usually a few large transactions or items and all of
them are material.
Considerations of importance for audit risk include adherence to a stated policy that all non-
current liabilities must be authorised by the board of directors, and formal assignment of respon-
sibility for monitoring compliance with the requirements and restrictions of debt agreements.
Accounting principles, including disclosure requirements, for non-current liabilities are volu-
minous and complex, so more audit emphasis is placed on the specific audit objective related to
disclosure.
Owners equity
Equity accounts differ depending on the form of organisation. This discussion focuses on
shareholders equity in a company.
The specific audit objectives and common audit procedures for shareholders equity are
substantially the same as for non-current liabilities, so a separate table summarising them is not
presented. The primary differences for particular procedures are as follows:
Confirmation Many companies use the services of independent share registry offices to
maintain detailed records of shareholders. In that case, confirmation requests are sent to those
agents. If a company keeps its own share records, the auditor examines the records rather than
sending confirmations to shareholders. The auditors chief concern when the company keeps
shareholder records is with the specific objective related to completeness. The auditor
examines the shareholder register and observes company procedures to ensure that all issued
shares are recorded and that all unissued shares are safeguarded.
General procedures In addition to reading the minutes of meetings of the board of directors,
the auditor would read the companys constitution. The description of shares as presented in
the financial report should correspond to the information in the companys constitution.
Authorisation of dividends should be in the minutes of board meetings.
Recomputation, vouching and tracing The auditors procedures for cash dividends are
similar to those for interest payments.
non-current liabilities are completeness and disclosure.
2 The main audit procedures are confirmations, reading minutes of meetings of the board
and examining debt agreements.
owners equity are completeness and disclosure.
4 The main audit procedures are inspection of shareholders registers or confirmation with
an independent share registrar, and reviewing the minutes of the meetings of the board
of directors.
learning
objective 9
THE STATEMENT OF FINANCIAL PERFORMANCE
As explained earlier, direct tests of balances generally focus on statement of financial position
accounts. In all of the explanations of assertions, objectives and procedures for components of the
financial report in previous discussions, the specific audit objectives are stated for statement of
financial position accounts. This section explains the relationship between specific audit
objectives for statement of financial performance account balances and those for statement of
financial position accounts. This is also an area where controls, such as budgets and variance
analyses, are very important in undertaking tests of balances.
Assertions and objectives

The financial report assertions presented in Chapter 5 are broadly worded to cover both statement
of financial position and statement of financial performance accounts. The broad categories of
financial report assertions that focus on statement of financial performance accounts are similar
to those applied to transactions, as follows:
Occurrence Reported revenues and expenses actually occurred during the period covered by
the statement of financial performance.
Completeness All revenue and expense transactions that occurred in the period covered by
the statement of financial performance are included.
Rights and obligations Reported revenues and expenses represent transactions to which the
client entity was actually a party.
Measurement Revenues and expenses are measured properly, and are recorded in the correct
period.
Disclosure Revenues and expenses are properly described and classified in the statement of
financial performance, and related disclosures in the financial report are adequate.
In a double-entry accounting system, testing one side of a transaction automatically tests the
other side. Thus a procedure that achieves an audit objective for one side of a transaction should
achieve a comparable audit objective for the other side.
Audit procedures for statement of financial

performance accounts
The account balances in the statement of financial performance are generally tested by one of the
following procedures:
Substantiation indirectly by simultaneous tests This category includes those statement of
financial performance account balances that are tested indirectly as a result of direct tests of
balances of related statement of financial position accounts. The primary statement of
financial performance account balances that usually fall in this category are sales, cost of sales
and many of the expense accounts.
Substantiation directly in conjunction with statement of financial position accounts Some
statement of financial performance account balances are subjected to direct tests of balances
in conjunction with tests of related statement of financial position accounts. Examples of these
account balances, with the related statement of financial position accounts shown
parenthetically, are as follows:
depreciation expense (property, plant and equipment)
amortisation expense (intangible assets)
investment income (investments)
interest expense (loans or notes payable).
Substantiation directly by analytical procedures The auditor usually applies several
analytical tests to statement of financial performance account balances as additional overall

tests of reasonableness, or to provide necessary assurances on appropriate classification or
completeness. Statement of financial performance account balances are compared with
amounts of previous periods and budgets. Also, the relationships of amounts that are expected
to follow a predictable pattern are considered. For example, a relationship should exist between
the amount of sales, cost of sales, accounts receivable and doubtful debt expense. When there
are significant variances from logical or historical relationships, the auditor should obtain
explanations, consider whether they are reasonable and follow up on information gained
through these explanations, as required by AUS 512/ISA 520 and by law (refer to the Pacific
Acceptance Corporation case in Chapter 4). Analytical procedures may be particularly
important for considering the appropriate classification of expenses.
Substantiation directly by separate direct tests Some statement of financial performance
account balances are usually substantiated by separate direct tests of balances. Generally,
these fall into two broad categoriesindividually significant transactions or events and
account balances of intrinsic interest.
Individually significant transactions or events

Some statement of financial performance items that enter into the determination of net profit are
individually significant, and the auditor applies separate direct tests of balances to these items.
Generally, the following items are significant:
Discontinued operations The results of discontinued operations and any related gain or loss
are reported separately from continuing operations. Usually, the amount is very material and
complex accounting issues are involved in the recognition of gain or loss.
Extraordinary items and specific revenues and expenses An item is extraordinary if it is both
unusual and unlikely to be recurring. Extraordinary items are reported separately from profit
and loss from continuing operations. The auditor also carefully considers any specific revenues
or expenses from ordinary activities which, because of their size and effect on operating profit,
are highlighted separately in the statement of financial performance in accordance with
AASB 1018/IAS 1 Statement of Financial Performance. The auditor may directly test the under-
lying transaction or event, and will carefully consider the required disclosure.
Accounting principle changes The cumulative effect of changing to a new accounting
principle also needs to be considered. The auditor needs to obtain evidence to evaluate
managements justification for the change, the accounting effect and treatment of the change,
the acceptability of the new accounting principle and the adequacy of the disclosures
associated with the change.
All of these items generally involve complex accounting issues. The auditor uses
recomputation to test the proper application of accounting principles, but audit procedures are
also usually necessary to substantiate the underlying transactions or event. In specific
circumstances, other transactions or events, such as a sale of land and buildings, may be
individually significant and would be tested directly.
Account balances of intrinsic interest

Some account balances are analysed and the details of items in the balance are vouched to
supporting documents because there is some interest in the account balance that is out of
proportion to the effect of the balance on net profit. For example, travel and entertainment
expenses and officers salaries often fall into this category because of the income tax implications
of these items, in particular potential obligations of fringe benefits tax. Another common
example is legal fees. The auditor is concerned with identifying all solicitors consulted by
management during the period. An analysis of the legal fees account is a good way to identify the
solicitors consulted and why they have been consulted. Because separate disclosures of all
auditors fees and directors fees are required, transactions underlying these accounts may also be
separately vouched.
1 Some statement of financial performance accounts are substantiated indirectly by tests
of balances of related statement of financial position accounts. These include sales, cost
of sales and many expenses.
2 Some statement of financial performance accounts are substantiated directly in
conjunction with tests of balances of related statement of financial position accounts.
These include investment income, depreciation, amortisation and interest expenses.
3 Necessary assurances on many statement of financial performance accounts are provided
by analytical procedures. These are account balances where the relationship of amounts
is expected to follow a predictable pattern, or account balances which individually are
not of sufficient risk or materiality.
4 Some statement of financial performance account balances are individually significant
because of their nature or size. These include extraordinary items, specific significant
revenues and expenses from ordinary activities, and items of intrinsic interest such as
travel and entertainment expenses and legal, auditors and directors fees. Details of
items in these accounts are usually vouched to supporting documents.
AUDITING WITH THE COMPUTER: TESTING 10 learning

objective
CLIENT FILES
If client files are voluminous, it can be efficient to apply audit procedures to records in their
computer-readable form. For example, a very large entity may have master files with over 100 000
individual records in applications such as inventory and accounts receivable. In these
circumstances it may be more efficient for the auditor to use a computer program to automate the
auditing procedures. An auditors program may be used with master files or transaction files, so
the audit procedures may be tests of details of transactions or balances. However, it is more
common to use an auditors program to test a clients master files. One of the main ways is to use
a program that is designed to read the data existing on a clients file, and undertake auditing tasks
on this data, including identifying items deemed to be of risk or material. How this is done will be
described in more detail below.
AGS 1060/IAPS 1006 Computer Assisted Audit Techniques (CAATs) identifies a number of
categories of CAATs. These include a number of evidence-gathering techniques involving the use
of computer programs:
Generalised audit software (GAS)

The most widely used form of CAAT is generalised audit software, which is also referred to in
AGS 1060/IAPS 1006 as package programs. A software package is used to perform specific audit
tasks, such as footing and comparing items, on a computer-readable file. A generalised
program that can perform several audit tasks for many clients is more efficient than programs
specially written for particular clients and tasks. However, a generalised package is not an all-
purpose device. The auditors software must interact with the operating system of the clients

computer. Particular packages are designed for families of hardware that use particular
operating systems. Large auditing firms have developed their own packages, and some software
vendors offer audit packages. In some cases, versions have been developed for different
hardware and operating systems.
Since there are many audit software packages, this discussion describes the general features of
this type of software. When generalised software is run, the first programmed step is to read the
clients file. The processing is performed on a copy of the clients file and the clients data are not
changed. The other two aspects of generalised audit software are:
1 File formats Client file formats vary considerably. For example, the number, type and size of
fields in a record on an accounts receivable master file differ widely from client to client. One
of the advantages of generalised audit software is its ability to deal with different file formats.
The file format is defined by the auditor as part of the input specification. Some packages
reformat the data in a standardised manner. The auditor specifies the file layout and the fields
and their location in the file.
2 Processing instructions Generalised audit software is designed to perform several types of
processing tasks. The package provides some means for the auditor to determine the particular
tasks to be performed. Several approaches are used. In many cases, the auditor fills out coding
or specification sheets to identify the tasks. In others, the auditor writes a simplified program
in a specially designed command language.
Generalised audit software programs that are currently available perform an extensive range of
functions and can:
select sample items (e.g. select customer balances for positive and negative confirmation);
identify records meeting specified criteria (exception reporting) (e.g. identify customer balances
over credit limit);
test and make calculations (e.g. recalculate interest charges);
compare data in separate fields or on separate files (e.g. compare change in balance of an
account with details on transactions files);
summarise data (e.g. summarise accounts receivable by age (one month, two months, etc.));
and
write reports (e.g. an accounts receivable confirmation letter or work paper account analysis).
Note that in general, audit software is used to test computer file data. It is difficult to test
system logic, except implicitly by the results that appear in the data files. These programs contain
no explicit testing of programmed controls. The existence of controls may be inferred. For
example, take a programmed control which does not allow the account balance to exceed the
credit limit. By undertaking an exception report, and observing no records where the account
balance is greater than the credit limit, the existence of this control may be inferred. However, the
control has not been directly testedthis would require the use of one of the auditing through the
computer techniques outlined in Chapter 9.
To make effective use of generalised software the auditor needs to plan carefully. Specific audit
objectives remain the same whether audit procedures are applied manually or with generalised
software. The starting point in both cases is to develop specific audit objectives from financial
report assertions. However, in using generalised software, it is extremely important to specify
objectives and criteria in advance of testing. The auditor who manually selects specified items
from the accounting records may notice other unusual items. When generalised software is used,
an item cannot be selected unless the auditor has completely specified the criteria for its selection
in advance.
EXAMPLE 10.4 Use of CAATs
You are auditing the accounts receivable of your client. The accounts receivable master file contains
the following fields:
Field Field Title

1 Debtor Number
2 Debtor Name
3 Debtor Address
4 Credit Limit
5 Outstanding Balance
6 Balance < 30 days
7 Balance 3060 days
8 Balance > 60 days
9 Total dollar value of transactions this year
10 Date of last transaction
Required
Describe how the auditor may use audit software to aid in verifying the existence and valuation
assertions of the debtors master file.
Solution
The main way in which the auditor verifies existence is to undertake a debtors confirmation
procedure or verify subsequent receipts from the debtors. Both of these techniques will involve the
auditor selecting a group of auditors outstanding balances to be tested. Thus the auditor would use
the sampling function of the audit software.
In testing for the valuation assertion, the auditor needs to identify accounts where there may be
a difficulty of payment. This will involve the auditor using the exception reporting function of the
audit software. Some of the exception reports may include:
Accounts with Outstanding Balance (field 5) greater than Credit Limit (field 4)
Accounts with amounts outstanding > 60 days (field 8 > 0)
Accounts where total dollar value of transactions (field 9) is less than outstanding balance (field 5).
If these accounts are identified, they too may be included in the debtors confirmation procedure or
review of subsequent receipts.
Specialised audit software (SAS)

If generalised audit software cannot be used on a particular clients computer, the auditor might
consider having a program written to accomplish specific audit tasks. SAS is also commonly
referred to as purpose-written programs.
Alternatively, there is currently available a wide range of SAS for specific industries, and it is
more efficient for major routines in these industries. For example, in the insurance industry there
are purpose-written programs for the calculation of premium income and reinsurance premiums,
which are major issues in the insurance industry. Another example of an application for purpose-
written programs is municipal council audits, where the calculation of rates is a major issue.
Specialised software can be written by auditors, outside programmers, software vendors or
client programmers. In deciding how to develop it, there is a trade-off between cost and inde-
pendence. Use of client programs or programmers, while normally cheaper, is less independent.
Utility programs
Software and hardware vendors have developed software designed to accomplish common tasks and
routines, such as sorting records or merging files. These types of routines are commonly available in
most major applications. The auditor can use a utility program to print the entire contents of a file,
merge files or sort records in a file into a sequence useful for an audit task (such as size or location).

Systems management programs
Systems management programs are defined in AGS 1060/IAPS 1006 as enhanced productivity tools
that are typically part of a sophisticated operating systems environment, for example data retrieval
software or code comparison software. These programs are sometimes suitable to assist with the
auditors objectives, performing functions such as retrieving data which meets specific criteria.
Management also has an interest in identifying and following up on records that are large or unusual,
for example debtors that havent paid for over 60 days, and this can be aided by such programs.
EXAMPLE 10.5 Using audit software: your chance to use ACL

The development of audit software, such as ACL, has resolved a persistent problem plaguing
auditorsthe difficulty of directly accessing client computer information. Recent innovations have
allowed auditors with little or no computer background to perform tasks that used to be reserved for
information system auditors. With the increased usage of personal computers (PCs) in the business
community and other advances in technology, auditors now enjoy greater access to client data,
directly from their PCs. Todays auditors are able to quickly access data to perform such tasks as sorting
files, sampling, exception reporting and analytical procedures.
In summary, Computer Assisted Audit Techniques (CAATs) are changing the way auditors perform
their responsibilities, allowing them to complete their audits more efficiently and more effectively.
Audit software is being used to analyse large data files, identify anomalies, compare fields, perform
queries, develop reports and document audit steps. More importantly, tests performed with the aid
of audit software can be performed on entire populations, rather than just samples. Internal auditors
can report to management on the basis of 100 per cent tests, thus giving management a complete
picture of the area in question.
For example, audit software may assist an auditor in comparing an Accounts Payable file, a Payroll
file and a Contractor file, to determine whether any current employees are being paid as contractors.
Similarly, lists of vendor addresses can be compared to employee address files to see whether
employees are paying invoices to companies that they own or operate. Finally, auditors can play a
consultative role by instructing clients on how to use CAATs for their own benefit.
For the most part, the widely used audit software packages are very similar. Most have been
developed from standard spreadsheet applications with which students are already familiar. These
specialised spreadsheet applications, however, have been modified such that common audit tasks can
be performed through accessing redeveloped macros at the touch of a button. In addition, the audit
software packages can handle much larger data sets than most spreadsheet packages.
The CD with this book contains a tutorial on using ACL audit software. It will allow you to become
familiar with the audit tests that can be applied using ACL. The CD also contains a case study using
ACL. If you wish to explore ACL further, there is also a web site demo <http://www.acl.com> that is
free for students. ACL asks you to indicate that you are a student, so that a salesperson will not follow
up on the contact.
1 The major technique for testing the clients files involves a program under the auditors
control. The program can be used to read the clients files and identify areas where the
auditor may wish to concentrate audit testing, and also to automate many time-
consuming processes.
2 Auditing with computer techniques includes the use of:
generalised audit softwareused with many clients;
specialised audit softwareprograms especially written for a client, task or industry;
utility programsroutines designed to accomplish common tasks for many clients;
systems management programsenhanced productivity tools that are typically
associated with sophisticated systems environments.
3 The functions that can be performed by such software include selecting sample items,
exception reporting, testing and making calculations, summarising data and report writing.
EFFECT OF STRATEGIC BUSINESS RISK ON 11 learning
objective
SUBSTANTIVE TESTS OF BALANCES

Based on the evidence gathered during the strategic business risk evaluation, including extensive ana-
lytical procedures, the auditor develops an expectation about each of the material accounts and the
key underlying assertions. If there is agreement between the auditors expectation and the account
balance, then it is expected that the auditor will reduce the amount of substantive testing of balances.
It is anticipated that there will be decreased emphasis given to substantive tests of routine
transactions, as it is expected that these will be well controlled and will carry little risk of material
misstatement. The auditor will use tests of controls to ensure that the expected controls are in
operation. The auditor will, however, pay attention to non-routine transactions (adjustments by
management to the accounts, such as provisions for doubtful debts or loans, provisions for
obsolescence of inventory, accrued revenue) of a material nature. Under the financial risk analysis
approach, these transactions should also have received audit attention. Thus the major effect of
the strategic business risk approach with regard to tests of transactions is that substantive testing
of routine transactions should be reduced.
The strategic business risk analysis approach emphasises a top-down approach. The auditor
gains a sound and comprehensive understanding of the clients business, strategy, associated risks
and industry to develop valid expectations about financial report assertions. This is supported by
increased sophistication in the use of analytical procedures and developing a model of expectations
of the financial position and performance of the entity. The traditional financial risk audit is effectively
a combination of top-down and bottom-up approaches. The top-down component includes an
assessment of inherent risks facing the entity, industry and economy. It also includes a bottom-up
component where the auditor gains an understanding of the business by selecting and testing specific
transactions and balances, and inspecting and validating supporting documentation. Thus there will
be less emphasis on the testing of account balances and inferring financial position and performance
under the strategic business risk approach compared with the traditional financial risk approach.
Impact of proposed business risk standards

The major change in the business risk standards affecting Chapter 10 is the changes in
STOP
P R E S S ! substantive procedures required due to the changes in assertions. These changes in assertions
were outlined in the Chapter 5 Stop Press! The assertions are now categorised around:
classes of transactions and events;
account balances; and
presentation and disclosure of financial information.
The major change is that the auditor will have to undertake more substantive procedures around presentation
and disclosure to ensure that adequate audit evidence is gathered to support the assertions under this category.
Summary
The auditor undertakes the most efficient and effective valuation and disclosure. For each of the major accounts
combination of tests of controls and substantive tests of or classes of transactions, this chapter has identified the
transactions and balances to achieve a required level of relative importance of the assertions and the substantive
audit risk. In undertaking substantive tests the auditor is audit procedures that would be used to gather audit
verifying the following assertions contained in account evidence for those assertions. The chapter has also
balances or classes of transactions: existence, occurrence, outlined the computer-assisted audit techniques that
completeness, rights and obligations, measurement, would be used in the gathering of audit evidence.

Keyterms
Bank confirmation requests 444 Physical inventory count 454
Bank reconciliations 446 Positive form of debtors confirmation 450
Bank transfer schedule 447 Pricing and summarisation 460
Complete inventory count 455 Purpose-written programs 479
Completeness 441 Retail inventory method 455
Confirmation 448 Rights and obligations 441
Cycle count 455 Routine transactions 481
Disclosure 442 Standard cost system 455
Dual-purpose tests 437 Stocktake 454
Existence 440 Substantive tests of transactions 437
Measurement 442 Systems management programs 480
Negative form of debtors confirmation 450 Tracing 437
Non-routine transactions 481 Valuation 442
Occurrence 440 Vouching 437
Package programs 477
References
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accounts receivable confirmations: An experiment using Charter, March, 767.
four techniques, Auditing: A Journal of Practice and Theory,
OLeary, C. (1993) Debtors confirmationshandle with care,
Spring, 7785.
Australian Accountant, May, 357.
Carleton, J. and Compton, C. (1988) Bank confirmations: A new
Pasewark, W.R. and Strawser, J.R. (1992) An investigation of
look, The CPA Journal, January, 936.
auditor judgements of the effect of preliminary analytical
Caster, P. (1992) The role of confirmations as audit evidence, procedures on the extent of substantive testing, Accounting
Journal of Accountancy, February, 736. and Finance, November, 91108.
Coderre, D. (1993) Computer assisted audit tools and Schwerseriz, J. (1987) Accounts payable confirmations: why and
techniques, Internal Auditor, February, 247. how used, The CPA Journal, May, 10193.
Edge, W.R., Farley, A.A. and Simnett, R. (1988) A review of the Windsor, S. (1991) The use of audit sampling techniques to test
capabilities and availability of generalised audit software, inventory, Journal of Accountancy, January, 10711.
The Chartered Accountant in Australia, November, 637.
Winograd, B. and Herz, R.H. (1995) Derivatives: Whats an
Fensome, M. (1993) Statement of Auditing Practice AUP 1 Bank auditor to do?, Journal of Accountancy, June, 7580.
Confirmation Requests, Charter, September, 323.
File, R.G. and Ward, B.H. (1995) Improving the results of second
request confirmation procedures, Auditing: A Journal of
Practice and Theory, Spring, 8793.
Assignments
MAXIMISE YOUR REVIEW QUESTIONS
MARKS! There are
approximately 30 10.1 The following questions relate to audit procedures for inventories. Select the best response.
interactive (a) During a clients stocktake you select a sample of items from the floor, count them and
questions on
substantive tests
trace the quantities to the inventory summary sheet. Which financial report assertion
of transactions is this audit procedure related to?
and balances A rights and obligations
available online at B valuation
www.mhhe. C existence
com/au/gay2e
D completeness
(b) Your client sells a high-technology product which is subject to frequent technological
improvements and design changes in order to keep current with the market. Based on
this information, for the inventory account, the assertion upon which you should
concentrate your audit procedures is:
A existence
B valuation
C rights and obligations
D completeness
(c) An auditor, having accounted for a sequence of inventory tags, traces information on
a representative number of tags to the physical inventory sheets. The purpose of this
procedure is to obtain assurance that:
A the final inventory is valued at cost
B inventory sheets do not include untagged inventory items
C all inventory represented by an inventory tag is bona fide
D all inventory represented by an inventory tag is listed on the inventory sheets
(d) A client maintains perpetual inventory records in both quantities and dollars. If the
assessed level of control risk is high, an auditor would probably:
A apply gross profit tests to ascertain the reasonableness of the physical
accounts
B insist that the client perform physical counts of inventory items several times
during the year
C request the client to schedule the physical inventory count at the end of the
year
D increase the extent of tests of controls of the inventory cycle
(e) Your clients inventory turnover has decreased from 8.2 times to 5.6 times during the
year. Based on this decrease, which financial report assertion would you be least
concerned with?
A rights and obligations
B existence
C completeness
D valuation
10.2 The following questions relate to audit procedures for accounts receivable. Select the best
response.
(a) During the process of confirming receivables as of 30 June, a positive confirmation
was returned indicating the balance owed as of 30 June was paid on 9 July. The
auditor would most likely:
A reconfirm the zero balance as of 9 July
B verify that the amount was received
C determine whether there were any changes in the account between 1 July and
9 July
D determine whether a customary trade discount was taken by the customer
(b) An auditor reconciles the total of the accounts receivable subsidiary ledger to the
general ledger control account, as of 31 October. By this procedure, the auditor would
be most likely to learn which of the following?
A An opening balance in a subsidiary ledger account was improperly carried forward
from the previous accounting period.
B An account balance is past due and should be written off.
C An October invoice was improperly computed.
D An October cheque from a customer was posted in error to the account of another
customer with a similar name.

(c) Which of the following is not a primary objective of the auditor in undertaking
substantive testing of accounts receivable?
A Establish existence of the receivables
B Determine the completeness of the recorded receivables
C Determine the approximate amount that can be expected to be received
D Determine the adequacy of the internal control structure
(d) An auditor should perform alternative procedures to substantiate the existence of
accounts receivable when:
A collectibility of the receivables is in doubt
B pledging of the receivables is probable
C no reply to a positive confirmation request is received
D no reply to a negative confirmation request is received
(e) Once an auditor has determined that accounts receivable have increased due to slow
collections in a tight money environment, the auditor would be likely to:
A review the credit and collection policy
B expand tests of collectibility
C increase the balance in the allowance for bad debts account
D review the going-concern ramifications
10.3 The following questions relate to audit procedures for investments. Select the best
response.
(a) Which of the following is not one of the auditors primary objectives in an examination
of marketable securities?
A To determine whether securities are the property of the client
B To determine whether securities are properly classified on the statement of
financial position
C To determine whether securities are authentic
D To determine whether securities actually exist
(b) Which of the following is the most effective audit procedure for verification of
dividends earned on investments in marketable equity securities?
A Comparing the amounts received with dividends received in the preceding year
B Tracing deposit of dividend cheques to the cash receipts book
C Recomputing selected extensions and footings of dividend schedules and
comparing totals to the general ledger
D Reconciling amounts received with published dividend records
(c) To establish the existence and ownership of a long-term investment in the shares of a
publicly traded company, an auditor ordinarily performs a security count or:
A determines the market price per share at the statement of financial position date
from published quotations
B confirms the number of shares owned with the issuing company
C relies on the clients internal control structure if the auditor has reasonable
assurance that the control procedures are being applied as prescribed
D confirms the number of shares owned that are held by an independent custodian
10.4 The following questions relate to audit procedures for property, plant and equipment.
Select the best response.
(a) In the examination of property, plant and equipment, which of the following does the
auditor not try to determine?
A The capital nature of items included in repairs and maintenance
B The reasonableness of the depreciation
C The adequacy of future replacement funds
D The extent of property disposed of during the year
(b) In violation of company policy, Warren Ltd erroneously capitalised the cost of painting
its warehouse. The auditor examining Warrens financial report would most likely
detect this when:
A observing during the physical inventory observation that the warehouse had been
painted
B examining maintenance expense accounts
C discussing the capitalisation policies with Warrens financial controller
D examining the construction work orders supporting items capitalised during the year
(c) An auditor analyses repairs and maintenance accounts primarily to obtain evidence that:
A non-capitalisable expenditures for repairs and maintenance have been recorded
in the proper period
B expenditures for property, plant and equipment have been recorded in the proper period
C non-capitalisable expenditures for repairs and maintenance have been properly
charged to expenses
D expenditures for property, plant and equipment have not been charged to expenses
10.5 The following questions relate to audit procedures for non-current liabilities and
shareholders equity.
(a) When a client company does not maintain its own share records, the auditor should
obtain written confirmation from the transfer agent and registrar concerning:
A guarantees of preferred share liquidation value
B the number of shares subject to agreements to repurchase
C the number of shares issued and outstanding
D restrictions on the payment of dividends
(b) The primary reason for preparing a reconciliation between interest-bearing
obligations outstanding during the year and interest expense presented in the
financial report is to:
A detect unrecorded liabilities
B ascertain the reasonableness of accrued interest
C assess control risk for securities
D determine the validity of prepaid interest expense
(c) An auditor would be least likely to use confirmations in connection with the exam-
ination of:
A property, plant and equipment
B long-term debt
C shareholders equity
D inventories
10.6 The following questions relate to the use of computer-assisted audit techniques.
Select the best response.
(a) Which of the following is true of generalised audit software packages?
A They each have their own characteristics which the auditor must carefully
consider before using in a given audit situation.
B They enable the auditor to perform all manual test procedures less expensively.
C They can be used only in auditing online computer systems.
D They can be used on any computer without modification.
(b) Auditors often make use of computer programs that perform routine processing
functions such as sorting and merging. These programs are made available by CIS
companies and others and are specifically referred to as:
A utility programs
B user programs
C compiler programs
D supervisory programs

(c) A primary advantage of using generalised audit software in the audit of an advanced
CIS system is that it enables the auditor to:
A verify the performance of machine operations which leave visible evidence of
occurrence
B gather and store large quantities of supportive evidential matter in machine-
readable form
C substantiate the accuracy of data through self-checking digits and hash totals
D utilise the speed and accuracy of the computer
(d) An auditor using audit software would probably be least interested in which of the
following fields in a computerised perpetual inventory file?
A date of last purchase
B quantity sold
C economic order quantity
D warehouse location
(e) While undertaking the audit of the debtors balance, you use your audit software to
extract from the accounts receivable master file a report which shows those debtors
with a positive balance owing and which is overdue by greater than 30 days. At which
of the following account balance assertions is this report aimed?
A valuation
B completeness
C existence
D occurrence
learning 1
objective Nature of substantive tests
10.7 What are the major differences between tests of controls and substantive tests of transactions?
learning 2
objective Assertions associated with substantive tests
10.8 Cut-off tests relate to testing transactions around balance date. To which assertion does
cut-off relate, what is its purpose and for which transactions is cut-off usually tested?
learning
objective 39 Testing of specific accounts
10.9 What factors influence the auditor in determining whether to use the negative or positive
confirmation method for accounts receivable?
10.10 What alternative audit procedures are acceptable in obtaining satisfaction about inventory
quantities?
10.11 What assertion is the auditors primary concern in tests of balances for liabilities? Why?
10.12 What are the auditors major concerns when auditing accounting estimates?
learning
objective 10 Use of computer-assisted audit techniques
10.13 Identify and explain the types of computer programs that are available for testing the
clients files.
10.14 What functions of generalised audit software are useful for audit tests?
DISCUSSION PROBLEMS AND CASE STUDIES

primary learning 2
objective Tests of transactions and balances
10.15 Basic You are carrying out the 30 June year-end audit of Riverina Limited, a large listed com-
pany. As part of year-end testing, your audit manager has obtained a report of all transactions
processed by the client in the month of June. The objective of the report was to obtain infor-
mation on all large and unusual transactions processed during the month, so that follow-up
testing could be performed. The manager has selected the following transactions for follow-up:
Dr Cr
$000 $000
1 Provision for obsolescence 400

Inventory 400
2 Cash 100
Investmentsshares in XYZ Pty Ltd 80
Gain on disposal of shares 20
3 Lease liability 84
Interest expense 6
Cash 90
Required
(a) Explain the likely transaction underlying each of the above journal entries.
(b) Describe the audit evidence you would gather in relation to each of the above journal
entries. Include discussion of the implications for other areas of the audit where
applicable.
10.16 Moderate Johns Jobs (JJ) is a small business providing home maintenance services in the
Blue Mountains area of New South Wales. John is interested in purchasing some new
machinery for his business and has approached a bank for funding. In order to be given a loan
the bank has requested an audited financial report. John has approached your firm for this
service and you have been allocated the task of auditing JJ. Your preliminary review of the
business indicates that a substantive testing approach would be appropriate and you are now
preparing audit programs. In particular you are working on the testing for the revenue cycle.
The information you have obtained from your review is as follows:
John usually works 50 hours a week. Part of this time is spent travelling between clients
and is not charged to the clients. The remaining time is charged at $40 per hour,
regardless of the task undertaken.
John is usually paid in cash, except for a small number of regular small-business
customers who John allows to pay on account on a monthly basis by cheque.
In all cases John provides the customer with a written receipt. Receipts are prepared
manually from a receipt book purchased at the newsagency. The book contains
prenumbered blank receipts, which are completed in duplicate.
Required
Provide one procedure you could use to audit each of the assertions of measurement,
completeness and occurrence for JJs revenue balance.
10.17 Moderate Consider each of the following material independent situations:
(i) You are auditing the sales and trade debtors of Eastern Block Limited (EB). All of EBs
customers are in Eastern Europe. Due to language differences, and the current
political situation in many countries, direct confirmation of debtors balances is
unlikely to give satisfactory results.
(ii) You are auditing the purchases and trade creditors at FE Pty Limited (FE). One of FEs
major creditors is very slow in sending invoices for goods delivered. Also, owing to a
quality control problem a large number of goods supplied by FE have been deemed
faulty and have had to be returned with a request for credit.
Required
(a) Identify the key audit assertion(s) at risk in relation to the balances described in each
of the situations above.
(b) Describe the audit procedures you would perform in order to gather sufficient,
appropriate audit evidence on each of these assertions.

10.18 Complex You have been assigned to the audit of LMN Limited (LMN), a large listed
company with diverse operations. During the audit you become aware of the following:
(i) LMN has a $5 million investment in RBT Pty Limited (RBT), a controlled entity based
in Russia. This company imports and sells Australian wheat, flour, yeast and other
bakery products to Russian manufacturers. With the devaluation of the rouble, sales
have plummeted and many customers are unable to settle their accounts. By year-
end, RBT expects to have incurred losses of over $3 million.
(ii) LMNs trade creditors are recorded in a ledger that is produced monthly. Lately
accounting staff have been having difficulties with the ledger as it has reached the
maximum permissible number of creditor accounts. Management have approved an
upgrade of the system, but in the meantime staff are having to keep extensive manual
records in order to derive accurate creditor figures.
(iii) One of LMNs controlled entities, ICE Pty Limited (ICE), is an ice-cream manufacturer.
Part of ICEs agreement with its distributors is that ICE will supply a freezer complete
with advertising signs for the distributors use. These freezers are rented out to the
distributors and recorded as fixed assets in the books of ICE. Most distributors are
either service stations or corner shops.
(iv) As with many other businesses, LMN is finding it extremely difficult to recruit and
retain skilled factory staff. Accordingly it has been decided that staff in the most
difficult to retain award categories will be rewarded with annual bonuses. These are
calculated using a relatively complex formula that takes into account employees
length of service, award rate, seniority and estimated contribution to profit.
Required
For each independent item (i) to (iv) above:
(a) Identify up to two key audit assertion(s).
(b) Outline the audit procedures you would perform to gather sufficient appropriate
audit evidence on each assertion.
Source: This question was adapted from the Professional Year Programme of The Institute of Chartered
Accountants in Australia1999 Accounting 2 Module.
primary learning 3
objective Substantive tests of cash, cash receipts and payments
10.19 Moderate C Pty Ltd (C) is a large company operating in the tourism industry. C has a
number of subsidiaries formed to concentrate on specific aspects of Cs activities (e.g.
ecotourism, harbour cruises, holidays, etc.). C and each of its subsidiaries have a bank
account, but the main banking activities of the group are undertaken through the bank
account of C. All of the accounts are maintained and monitored by Ms X, the senior banking
clerk of C. Your preliminary discussions with Ms X indicate the following:
Subsidiary bank accounts are used for depositing the proceeds of the tourism
operations.
All expenses of the group are paid by C. These expenses include the costs of tourism
operations.
Each of the subsidiaries then reimburses C for costs associated with its activities
together with a management fee. Reimbursement occurs on a monthly basis and is
completed via a direct transfer between the bank accounts authorised by the financial
controller of C and the CEO of the relevant subsidiary.
Ms X is responsible for preparing a schedule of transfers each month and reconciling
each of the bank accounts.
Required
(a) Identify the assertions that are most likely to be assessed as high risk for the cash
balances of C and its subsidiaries. Provide reasons for your decision.
(b) Provide three procedures which could be used to minimise this risk. For each
procedure indicate the assertion addressed.
4 primary learning
Testing of accounts receivable objective
10.20 Moderate You are the audit senior assigned to the audit of Chocorama Pty Ltd (C), a
manufacturer and wholesaler of chocolate products. Your assistant has performed a
positive debtors circularisation of 50 of Cs debtors, with the following results:
1 No reply has been received for eight confirmations.
2 Four debtors confirmation letters have been returned unopened marked No longer
at this address.
3 One confirmation letter was returned signed but with no indication on the
confirmation letter whether the account balance was correct or incorrect.
4 Four confirmations were received indicating that the balance was incorrect. The
assistant followed this matter up with the debtors clerk and found that C had issued
credit notes after year-end and the balance confirmed by the debtors reflected the
details of the credit notes.
Required
Indicate the effect of the above findings on the audit approach, specifically identifying the
risk that has been highlighted as a result of the audit testing performed, and any additional
procedures which you consider that your assistant should perform.
10.21 Moderate R Inc. is an Aussie Rules club operating in the suburbs of Melbourne. You have
been assigned to the audit of unearned revenue and accounts receivable for the club.
Unearned revenue comprises membership fees paid in advance and accounts receivable
comprises late membership fees. Your discussion with the clubs manager has indicated the
following:
The club was formed for the purpose of supporting a local Aussie Rules competition. It
provides sporting and social facilities for its 15 000 members.
Membership fees are $30 per person payable annually. Membership is usually paid in
advance in December of the previous year. If members do not pay by 31 December the
club allows non-financial members to use the clubs facilities for a period of three months.
After this time they must pay their membership or they will not be allowed to use the
facilities. The club accounts for the past-due members fees as accounts receivable.
Where membership is not renewed after the three months the debt is written off.
Past experience indicates that approximately 60 per cent of members will pay in advance.
Of the remaining 40 per cent, 20 per cent of total members will pay in January and 15 per
cent will pay in February. Only 5 per cent of members do not renew membership.
Required
(a) Indicate two procedures you could use to audit unearned revenue for the 31 December
review of R Inc.s financial report.
(b) Indicate two procedures you could use to audit accounts receivable for the 31 December
audit of R Inc.s financial report.
5 primary learning
Testing of purchases and inventories objective
10.22 Basic In auditing a company engaged in wholesaling goods, you find that a very
substantial part of the inventory of merchandise is on consignment to customers in other
cities and at independent warehouses in other cities. State the procedures you would follow
in your tests of the inventory on consignment and in warehouses.
10.23 Complex Your client, Sharina Ltd, manufactures baby carriages as its only product. The
corporation maintains perpetual inventory records in quantities and values, and also
takes a complete physical inventory each 30 April. You observed the physical inventory on

30 April 20X0 and were satisfied with the procedures followed. From your test counts, you
are satisfied that the clients counts were substantially accurate. There were differences
between the clients count and the perpetual records for about 75 per cent of the items.
Before adjusting the inventory records for the larger differences, of which there were about
25, the records were checked and the items were recounted. Typical examples of
adjustments for the larger differences are as follows:
Perpetual record Perpetual record

before adjustment after adjustment
Black paint (in litres) 662 647

Cotter pins (in dozens) 2260 2160
Hub caps 8592 8703
Assembled wheels 6901 6883
Sharina Ltd made no further physical tests of inventories during 20X0. For its year-end
closing at 30 June 20X0, the company used inventory quantities shown by perpetual
inventory records.
Required
Prepare in outline form an audit program setting out the essential procedures to be
followed in your audit of inventories as of 30 June 20X0. Do not include procedures unless
you believe them to be essential under the conditions as stated.
Source: AICPA adapted
primary learning 6
objective Substantive tests of accounts payable and cash payments
10.24 Moderate In auditing trade creditors, the audit assistant has:
selected a sample of creditors from the year-end creditors ledger;
vouched each creditors balance to selected invoices and subsequent cash payments;
and
agreed the total of the creditors ledger to the trial balance and general ledger.
Required
(a) Which audit assertion is each of the procedures performed by the assistant directed
towards?
(b) Identify the assertions you believe the assistant should perform further testing on.
Ignore disclosure issues.
(c) In relation to the assertions identified in (b), what additional procedures would you
advise the assistant to perform in order to gather sufficient appropriate audit evidence?
primary learning 7
objective Substantive tests of non-current assets
10.25 Basic You have been assigned to the audit of Investments for P Ltd (P) and its subsidiaries.
The treasury department of P undertakes investments on behalf of P and its subsidiaries. P
has an active investment strategy, involving the purchase and sale of all types of
investments, including listed and unlisted shares and fixed interest securities. Investments
are currently valued at $5 million.
Required
(a) Which assertion(s) are likely to be considered the highest risk for the audit of
investments at P?
(b) Provide three procedures that could be used to test the valuation assertion for
investments at P.
10.26 Complex You are the audit senior on the audit of ABC Limited, a chemicals manufacturer.
A significant asset in the statement of financial position of ABC Limited is the property,
plant and equipment balance, which is made up as follows:
Estimated balance at year-end

$000s
Freehold land and buildings (at cost) 25 000

Provision for depreciation (4 000)
21 000
Chemical plant and equipment 140 000
Provision for depreciation (37 000)
103 000
Office furniture and equipment 750
Provision for depreciation (280)
470
Capital works-in-progress 12 000
ABC Limited has other assets of $95 million and other liabilities of $170 million. From
discussions with management you are aware of the following:
The directors have decided to revalue the freehold land and buildings as land values
have risen and they consider that the statement of financial position will look better
with a higher asset value. The revaluation of freehold land and buildings is to be
performed by Mr X, an independent valuer.
The ammonia plant (with a carrying value of $10 million) is currently shut down. Due
to low market prices it has been cheaper for ABC Limited to import ammonia for use in
the production of other chemical compounds than to produce it themselves.
The capital works-in-progress relates to a new hydrochloric acid plant which is expected
to be completed five months after year-end. This will replace the existing hydrochloric
acid plant, which will be dismantled once the new plant is commissioned.
Required
(a) Identify the audit objectives for the property, plant and equipment balance of ABC
Limited.
(b) Identify the main areas of inherent risk in the property, plant and equipment balance.
(c) Outline specific procedures you would include in the audit program for the property,
plant and equipment at ABC Limited.
8 primary learning
Substantive tests of liabilities and owners equity objective
10.27 Moderate You have been assigned to the audit of shareholders equity of AB Ltd (AB), a
large publicly listed company. AB uses the services of ShareReg Pty Ltd, an independent
share registry office, to maintain detailed records of their shareholders. Your preliminary
review of this area has revealed the following information:
One month prior to year-end AB had a large share issue. The share issue was 90 per
cent subscribed.
Prior to the share issue, AB declared a dividend to its existing shareholders. The
dividend remains unpaid at year-end.
Required
Outline the audit procedures you would undertake in order to obtain sufficient appropriate
audit evidence in respect of the share issue and dividend payment.

primary learning
objective 9 Substantive testing of statement of financial performance
10.28 Moderate In auditing payroll expense, the audit assistant has:
selected a sample of individual pays from the monthly payroll listings of May and June;
vouched the pay rates used to the related industrial awards;
checked the calculations of each pay;
traced any annual, sick and other leave to authorised forms; and
agreed the balance of the payroll listings for May and June to the general ledger.
Required
(a) Which audit assertion is each of the procedures performed by the assistant directed
towards?
(b) Identify the assertions you believe the assistant should perform further testing on.
Ignore disclosure issues.
(c) In relation to the assertions identified in (b), what additional procedures would you
advise the assistant to perform in order to gather sufficient appropriate audit evidence?
primary learning 10
objective Use of computer-assisted audit techniques
10.29 Basic F Financing Pty Ltd (FF) is a subsidiary of F Ltd, a large motoring company established
to provide finance to purchasers of F Ltds products. One of the largest balances in FFs
accounts is interest income. Interest income is calculated using software specifically designed
for FF. You are currently designing a testing strategy for this balance and believe that the use of
computer-assisted auditing techniques (CAATs) may be appropriate, but you are unsure of the
type of CAAT which should be used. You have approached a colleague in the information sys-
tems audit area who has suggested that you use either generalised audit software or test data.
Required
(a) Indicate how each of generalised audit software and test data could be used to assist
with the audit of interest income at FF.
(b) Identify and describe the key factors that should be considered when choosing
between the two types of CAATs identified.
10.30 Moderate KJA Pty Limited is a manufacturer of fishing equipment and has recently
installed a computer system to maintain its inventory records.
An inventory listing can be obtained from the computer system, which provides data
in the following format:
item codea six-digit number, the first two digits indicating the physical location of the
item
item description
quantity on hand
unit cost
total value on hand
date of last sale
quantity sold during the year and the sales value of the stock sold
suppliers code number (the company has a list of preferred suppliers).
Required
Prepare a list of reports that could be obtained from the stock ledger of KJA Pty Ltd by the use
of GAS and indicate ways in which those reports could be used to achieve audit objectives.
10.31 Complex Simbuck Ltd is a medium-sized printing company. As part of its management
incentive policy, top management are given a bonus equivalent to 50 per cent of their
salary if they increase the return on total assets ratio (operating profit to total assets) above
that of last year, which was 2 per cent. An interim financial report has been prepared by the
client which shows a return on total assets of 2.1 per cent.
Your assessment of inherent risk suggests that a major audit exposure lies in the area
of non-current assets. It was noted during the planning phase that the majority of this
years additions to non-current assets are building improvements. Practically all of the
work was done by Simbuck Ltd employees, and the cost of materials and overheads was
paid by Simbuck Ltd. Because of the immaterial nature of these additions last year, no
follow-up audit work was undertaken.
It is also noted that the company had revised its depreciation rates at the beginning of
the year.
The non-current assets master file contains the following information:
Field no. Field title

1 Asset number
2 Description
3 Asset category 01land
02buildings
03equipment
04fixtures and fittings
4 Invoice costs
5 Additions/improvements during year
6 Date of purchase
7 Last date of improvement
8 Depreciation rate
9 Accumulated depreciation (beginning-of-year)
10 Depreciation expense for year
11 Accumulated depreciation (end-of-year)
12 Written-down value (end-of-year)
13 Estimated residual value
14 Date sold
15 Proceeds from sale
16 Profit/loss on sale
This master file is updated monthly for additions, improvements and deletions.
The additions transactions file contains the following fields: field nos 1, 3, 4, 5, 6, 8.
The improvements transactions file contains the following fields: field nos 1, 5, 7.
The deletions transactions file contains the following fields: field nos 1, 14, 15.
Required
(a) After a review of the general control environment you have concluded that tests of
control of application controls are appropriate. Identify programmed controls that
you may expect to see in the program which creates the additions transactions file.
Using as an example one of these controls identified, describe the procedures by
which the auditor would gain confidence that the control is working.
(b) A batch-input batch-processing system is used for updating the non-current assets
master file. Give examples of application controls, other than programmed application
controls, that the auditor may expect to see associated with such a system and which
would provide evidence of the completeness and accuracy of input and processing.
(c) (i) Given the return on total assets identified in the interim financial report of 2.1 per
cent, would the auditor be more concerned with upward or downward move-
ments in depreciation rates from last year? Why?

(ii) Outline an exception report that may be useful to the auditor in identifying
depreciation rates on which the auditor should concentrate audit attention, and
in identifying which audit steps should be undertaken with regard to this report.
10.32 Complex You are auditing the superannuation fund of your audit client. This client main-
tains its own superannuation fund for its employees. The employees are paid fortnightly,
and at every pay period 7 per cent of their gross wage (not including any overtime) is
deducted from each and every employees account and transferred to an equivalent
account for that employee which is maintained on the superannuation fund master file.
Thus every employee who is included on the payroll master file should be included on the
superannuation fund master file. The employees can be identified on both master files by
their unique employee number. The company then contributes an equivalent amount to
the superannuation fund for every employee.
This total amount is invested in government bonds at a rate of 10 per cent per annum.
After a 2 per cent management fee is taken out, these earnings are added to a field on the
superannuation fund master file called interest earned on invested funds (during the year).
Your evaluation of the general controls indicates that they are reliable.
You have access to the superannuation fund master file, the payroll master file and the
26 payroll transaction files. The superannuation fund master file contains the following fields:
Field no. Field title

1 Employee number
2 Employee name
3 Employee address
4 Superannuation contributions by employee (beginning-of-year balance)
5 Superannuation contributions by employee (during the year)
6 Superannuation contributions by employee (end-of-year balance)
7 Superannuation contributions by employer (beginning-of-year balance)
8 Superannuation contributions by employer (during the year)
9 Superannuation contributions by employer (end-of-year balance)
10 Interest earned on invested funds (beginning-of-year balance)
11 Interest earned on invested funds (during the year)
12 Interest earned on invested funds (end-of-year balance)
13 Total employee entitlement (end-of-year balance)
The arithmetic checks (field 4 + field 5 = field 6, field 7 + field 8 = field 9, field 10 + field 11
= field 12, field 6 + field 9 + field 12 = field 13) have already been carried out by the auditor.
Required
(a) Detail where and how the auditor may use analytical procedures in verifying the
valuation assertion contained in field 13 for the superannuation fund. Detail also how
analytical procedures can aid in auditing payroll expense, a field on the payroll master
file of the audit client.
(b) Detail how the auditor would use computer-assisted audit techniques (CAATs) to aid
in the assessment of control risk.
(c) Describe how the auditor would use CAATs to aid in verifying the completeness of the
superannuation master file.
(d) Compare and contrast the major differences between audit software approaches and
test data approaches.
(e) Describe how an integrated test facility could be used in the superannuation fund sys-
tem and whether it would provide evidence of a compliance and/or a substantive nature.
10.33 Complex You are currently auditing S Credit Union (S), a small state-based organi-
sation with branches in regional locations. S holds a portfolio of around 2000 mortgages
over residential owner-occupied properties. The mortgage ledger is maintained on a
computer file which includes the following fields:
Field Description
1 Mortgage registration number
2 Date of commencement
3 Original principal
4 Mortgage term
5 Interest rate
6 Balance outstanding: due within 12 months
7 Balance outstanding: due after 12 months
8 Provision amount (if applicable)
9 Credit rating (A to D)
Your manager has decided that generalised audit software should be used to perform
as many of the tasks involved in auditing mortgages as possible.
Required
(a) Describe the reports you would have the generalised audit software produce. Include
details of the report title, fields used, the use you would make of the report and the
audit objectives each report would help achieve.
(b) Assume S Credit Unions internal audit department has offered to lend you the software
program they use to verify mortgages outstanding. In comparison to using your gener-
alised audit software, what are the advantages and disadvantages of accepting their offer?
CONTINUOUS CASE STUDY
10.34 Complex This is a continuation of question 9.28. It may be completed independently of

that question.
You are currently involved in the audit of HomeChef Pty Ltd (HC), a large private
company operating in the boutique food and beverages market. The company has a
balance date of 31 December. To maximise audit efficiency, the audit partner has decided
to use the work of the internal audit group (IAG) to assist with the testing of controls.
The manager of IAG has given you a copy of the work performed to ensure payments
made to creditors throughout the year were in accordance with procedures laid down in the
Accounting Manual. After assessing the adequacy and competency of the work performed
by IAG and the results of their testing you believe it will not be possible to rely on controls
in the creditors area and have decided to use a substantive approach to audit this area.
The balance of trade creditors at 31 December 20X1 is $111 680 000. The net assets and
net loss of HC at the same date are $11 520 000 and $167 442 000. Total liabilities are
approximately $607 million. This balance includes secured loans of $424 million of which
$380 million is current. The loans are secured by a charge over the companys property and
are subject to a covenant agreement which requires that the company maintain a net
tangible asset ratio which is positive. Current assets are $90 138 000.
Required
(a) Identify the financial report assertions that carry the greatest risk in the audit of HCs
creditors.
(b) For each of the risk areas identified indicate two procedures which could be used to
provide audit evidence.

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10

identify the financial report assertions associated

explain the specific audit objectives and the common audit

9 identify several different audit approaches that may

10 describe and understand the use of computer-assisted

11 appreciate the impact of assessing strategic business

Relationship between tests of controls and

Relationship between substantive tests of

CHAPTER 10 Substantive tests of transactions and balances 437

Able 5000 Sale 2000

Accounts receivable Cash Accounts payable

Beginning balance Beginning balance Beginning balance

FINANCIAL REPORT COMPONENTS AND AUDIT 2 learning

OBJECTIVES FOR DIRECT TESTS OF BALANCES

Specific audit objectives

CHAPTER 10 Substantive tests of transactions and balances 439

Balances, therefore Transactions, therefore

Existence Concerned with whether assets X

Specific audit objectives

Financial report assertion Statement of financial position Statement of financial

EXAMPLE 10.2 Difficult areas associated with rights and obligations

CHAPTER 10 Substantive tests of transactions and balances 441

EXAMPLE 10.3 Relationship between valuation and measurement

Specific audit objectives

Financial report assertion Statement of financial position Statement of financial

Nature of the item and available evidence

CHAPTER 10 Substantive tests of transactions and balances 443

Assertions, objectives and procedures

Confirmation of bank balances

Financial report Common audit procedures

Existence Cash in the statement of financial Bank confirmation

Completeness Cash in the statement of financial Tests of bank reconciliations

Rights and Cash in the statement of financial Bank confirmation

Valuation Cash in the statement of financial Tests of bank reconciliations

Disclosure Cash balances are properly described General procedures

1 Bank ConfirmationAudit Request (General) The information contained on this

CHAPTER 10 Substantive tests of transactions and balances 445

Tests of a clients bank reconciliations

Extended cash procedures

CHAPTER 10 Substantive tests of transactions and balances 447

Financial report Common audit procedures

Existence Accounts receivable are authentic Confirmation

Completeness Accounts receivable include all Analytical procedures

Rights and Accounts receivable are owed to the General procedures

Valuation Accounts receivable are presented at Review of aged trial balance

CHAPTER 10 Substantive tests of transactions and balances 449

CHAPTER 10 Substantive tests of transactions and balances 451

To: [Auditor's Name] ..........................................................................

Alternative procedures to confirmation

CHAPTER 10 Substantive tests of transactions and balances 453

Differences from the sales and expenditures

Nature and frequency of accountability tests

Importance of accounting principles

Materiality and method of allocation

CHAPTER 10 Substantive tests of transactions and balances 455

It is usually tested indirectly by tests of inventory and expenditures.

Assertions, objectives and procedures

Financial report Common audit procedures

Existence Inventories included in the statement Inspection of physical inventory