Substantive procedures for material classes of transactions, account balances, and disclosures are always required to obtain sufficient competent audit evidence due the limitations of internal controls and the subjective nature of the auditor’s judgments when making risk assessments regarding the entity and its environment. Therefore, regardless of the assessed risk of material misstatement, the auditor should design and perform substantive procedures for all relevant assertions related to each material class of transactions, account balances and disclosures to obtain sufficient, appropriate audit evidence.
Analytical procedures consist of absolute comparisons of dollar balances with prior years’ account balances, or with budgets, ratio comparisons and trend analysis, and computations based on financial or operational data designed to predict the balance in a general ledger account. Analytical procedures also extend beyond numerically-based procedures to become a part of an auditor’s thought process.
Challenging financial information or the lack of such information that appears unusual, maintaining a positive, healthy skepticism when considering client responses to inquiries, and searching for the cause of a problem beyond its symptoms are examples of analytical thinking. The term “professional skepticism” is used in the literature to describe this kind of thinking. It is loosely defined as neither blindly trusting every client or, on the other hand, considering each client dishonest as we gather information.
Most common analytical procedures are corroborative in their nature. Their primary purpose is to corroborate evidence gathered from other tests designed to verify financial statement assertions.
When the results of analytical procedures contribute evidence to verify financial statement assertions, related tests of balances can be reduced at least to a limited extent.
The extent of the reductions of tests of balances depends on the effectiveness of the analytical procedures. Determination of the effectiveness of a procedure must be based on the procedure’s contribution of evidence for verifying the financial statement assertions. Computations designed to predict the balance in a general ledger account based on audited financial or operational data, e.g. quantity reconciliations and reasonableness tests, are normally the most effective analytical procedures. Corroborating procedures performed at lower levels of detail are more effective than corroborating procedures based on balances of financial statement classifications.
Reading (Scanning) the General Ledger
One of the most pervasive analytical procedures is reading, or scanning, the general ledger account activity. Whether done manually, or with the assistance of data extraction software, this analytical procedure is discussed for the first time in professional standards in SAS Nos. 106 and 109 (also in their redrafted counterparts).
Many auditors customarily perform this procedure but fail to consider its affect on their audit strategy. After any errors are corrected by proposed journal entries, the auditor has obtained significant, substantive evidence that relevant assertions for many account balances are reasonable. The evidence obtained from this risk assessment procedure should enable the auditor to reduce the assessed level of risk of material misstatement and, therefore, the extent of evidence desired from detailed tests of balances.
This procedure is usually performed by looking for unusual amounts or postings, transactions or general journal entries greater than the lower limit for individually significant items, checks or disbursements to be used in support tests, and other unusual matters. Documentation of the procedure should include the parameters of the test, the exceptions the test revealed and the resolution of the exceptions in a spreadsheet, memo or other working paper.
Tests of Balances
Substantive tests of the details of general ledger account balances include, among other evidence collection procedures, the following:
- Physical examination of assets.
- Confirmation of account balances.
- Inspection of support for transactions and balances.
- Observation of the work of client personnel.
- Inquiries of client personnel.
- Tests of the mechanical accuracy of balances.
The substantive tests of balances normally make the most substantial contributions to verification of the financial statement assertions. They are ordinarily, however, the most expensive types of tests.
Evaluating the Completeness Assertion
When tests of balances or analytical procedures can be performed to efficiently verify the completeness assertion, tests of controls are not necessary for this purpose. Verifying the completeness of revenues through tests of balances, however, is difficult at best.
Examples of substantive tests that can be used to verify the completeness assertion for revenues include examining contracts to determine all revenues that should be recorded are recorded (for the construction industry) or using predictive analytical procedures to determine the accuracy of recorded revenues or expenses, e.g., using copy machine meter readings for a copying business to compute copying revenues and copy machine rental expense. In other instances, limited tests of controls may be necessary to evaluate the completeness of revenues. Tracing, say, 10 to 15 or more documents originating sales transactions, e.g. customer orders or shipping reports, to the sales journal is an example of a limited test of control procedure for completeness.
For more information regarding auditing revenues and other financial statement classifications, live and on-demand webcasts, and self-study courses, are available by clicking the applicable box on the left side of my home page, www.cpafirmsupport.com.