Developing the Strategy
To select the proper strategy and prevent over auditing, the auditor must consider (1) the opportunity to assess risk of material misstatement at less than maximum and (2) the relative efficiency with which substantive tests of balances procedures can be performed. When a client has good internal controls and/or a good accounting system, using tests of controls may be the most cost-efficient strategy. However, when we can perform other risk assessment procedures, e.g., reading the general ledger and performing a systems walk-through procedure, and slightly reduced substantive tests of balances to evaluate relevant financial statement assertions in minimum time, detailed tests of controls would not ordinarily be necessary.
Since the evaluation of the risk of material misstatement is made at both the financial statement and the assertion level, and because tolerable misstatement must be determined for each material financial statement classification, the auditor may achieve efficiencies by planning unique audit strategies for each financial statement classification.
Effects of Inherent Risks
Inherent risk is the risk inherent in a transaction or account balance without considering internal controls. As we consider the design of an audit strategy, it is important to remember the higher the inherent risk in a transaction or balance, the higher the reliance normally required for tests of balances procedures.
Effects of Control Environment on Control Risk
The more effective the client’s control environment, the lower the assessed level of control risk. The lower the control risk, the lower the necessary reliance on tests of balances. A more effective control environment normally results in a stronger accounting system and the effectiveness of owner or manager key controls. A less effective control environment normally results in deficiencies in the design and operation of internal controls.
Effects of Low-Reliance Tests of Controls or Walk-Through Procedures
Deciding to perform low-reliance tests of controls, other risk assessment procedures or a system’s walk-through procedure, when a client has a good accounting system and control environment, may permit an evaluation of risk of material misstatement at slightly less than high to moderate. When risk of material misstatement is slightly less than high or moderate, some sampling and non-sampling procedures may be reduced.
These limited reductions of tests of balances will generally occur by:
1. Raising the lower limit for individually significant items from approximately 10% of the tolerable misstatement up to a level that may include the tolerable misstatement amount for each financial statement classification.
2. Using less reliable procedures for the lower stratum in a sampling population, such as sending negative confirmations for small accounts receivable balances.
3. Risk factors on a sampling planning and evaluation form can be reduced somewhat. Without good prior experience with the client, and without significant substantive evidence from analytical procedures, the risk factor would be close to 3.0. These factors remaining the same and control risk at slightly less than maximum or moderate could allow a risk factor of from 2.3 to 3.0.
4. Certain tests of balances procedures may be performed before the engagement date. Accounts receivable, for example, could be confirmed up to 30 days before the engagement date with appropriate roll-forward procedures.
My live and on-demand webcasts cover these and other subjects that contribute to performing high quality engagements in the least amount of time. You can download a syllabus or register by clicking the applicable box on the left side of my home page, www.cpafirmsupport.com.