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Clarified Auditing Standards: Audit Evidence – Part 2 (AU-C Section 500)

Jun 18th 2015
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In part 1, I discussed the basic types of tests that are necessary under AU-C Section 500. In this article, analytical procedures and tests of balances will be discussed.

Analytical Procedures
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 information is gathered.

The most common analytical procedures are corroborative in nature. Their primary purpose is to corroborate evidence gathered from other tests designed to enable an auditor to evaluate financial statement assertions.

When the results of analytical procedures contribute evidence to evaluate 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 evaluating 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 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.

The following are examples of analytical procedures, in the order of their effectiveness.

1. Quantity reconciliations. Multiplying the number of units sold times sales price, or the number of employees times weekly or monthly salaries, for example, can contribute evidence that will enable an auditor to evaluate substantially all the financial statement assertions for the applicable general ledger account. Only a few other tests of balances would ordinarily be necessary for the affected accounts if the data used in the computations has been audited.

To achieve maximum effectiveness, the reliability of the underlying data for these procedures must be established by other tests. For example, performing a quantity reconciliation for copy sales by a quick-copy business would simply require multiplying the number of copies sold times sales price. The number of copies could be obtained from the client’s copy log; however, beginning and ending numbers from the meter would need to be physically obtained to establish the reliability of the log. To determine that the meter had not been altered, it may also be necessary to trace the number of copies to billings for copy machine rentals from the supplier. Copy prices would have to be determined by references to sales tickets or price lists.

2. Reasonableness tests. Depreciation computations performed by computing depreciation by financial statement classification and method, based on average lives and one-half year for additions and disposals, is an example of a reasonableness test. Computing interest expense based on average note balances and interest rates is another example.

Different from quantity reconciliations, reasonableness tests are based on averages and estimates. Reasonableness tests are not as effective as quantity reconciliations in providing evidence to evaluate financial statement assertions. Because they are usually applied to smaller account balances, however, other tests of balances may not be necessary. Other limited tests of controls or balances may be necessary to complete the evaluation of the relevant assertions for material balances.

3. Corroborating procedures. The most common analytical procedures, such as absolute dollar comparisons of account balances and ratio analysis, provide evidence that corroborates other tests of controls and balances. While using corroborating analytical procedures may enable some modification of the nature, extent, and timing of tests of balances procedures, more tests of balances procedures will ordinarily be necessary for satisfactory evaluation of the financial statement assertions.

The lower the level of detail of the corroborating procedures, the more effective they are. Gross profit margin computed by product line, for example, is more effective than when computed using amounts in financial statement classifications. Risks of material misstatements, in other words, are more easily identified using corroborating procedures at lower levels of detail.

SAS No. 56, redrafted in AU-C Section 520, Analytical Procedures, instructs auditors to perform analytical procedures during the planning phase of an engagement to help identify potential risks of misstatements. SAS No. 109, redrafted in AU-C Section 315Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement, re-emphasizes the use of analytical procedures as risk assessment procedures. Analytical procedures should also be used during the review phase of an engagement to evaluate the results of an auditor’s completed work.

Minimum analytical procedures performed during planning may consist of comparing material unadjusted, current-year account balances with prior-year final balances. Significant variances usually indicate the need for adjusting journal entries. These differences should be investigated, documented in the working papers, and, if necessary, adjustments proposed to correct errors or post-year-end adjustments.

Placing high reliance on corroborating or predictive procedures requires, simply, that all variances are investigated and appropriate corrective action is taken by an auditor. From the investigation, the auditor may determine that the variance is not indicative of a problem, or on the other hand, that it is caused by an error or conditions that could cause errors in financial information. The auditor may, or may not, determine adjustments are necessary.

If analytical procedures can be performed extensively for high reliance during planning, related tests of balances procedures should be reduced. If extensive analytical procedures cannot be performed until engagement completion, as in the case of small clients with weak accounting systems, past experience can be relied upon to anticipate favorable results and plan for reductions in tests of balances. To repeat this significant time-savings opportunity, reductions in tests of balances evidence may be achieved by placing high reliance on analytical procedures performed during the risk assessment process.

Other Substantive Tests of Balances
Substantive tests of the details of general ledger account balances include 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 make the most substantial contributions of evidence for evaluating the financial statement assertions. The larger the engagement, the higher the costs of obtaining most evidence from the tests of balances will likely be. When the client has good internal-control procedures or a good accounting system, high reliance on tests of balances may not be the most efficient audit strategy.

On some engagements, auditing in the least amount of time may best be accomplished by a combination of evidence from risk assessment procedures, including tests of controls and/or system’s walk-through procedures, analytical procedures, and tests of balances. The auditor should always endeavor to design an audit strategy that produces necessary evidence in the least amount of time.

More Information
These eBook resources, without CPE credit, can be obtained from my website:

  • Small Audits Made Easy and Profitable
  • Performing Auditing Tests of Balances Procedures
  • Staff Training Series for Entry-Level Accountants, New In-Charge Accountants and Engagement Leaders
  • Key Accounting Issues for Non-Profit Organizations
  • A Practical Potpourri of Time Savings on Audits
  • The Financial Reporting Framework for Small- and Medium-Sized Entities

My exclusive presentation of webcasts on and self-study courses covering various applications of auditing standards can be accessed by clicking the appropriate box on the left side of my home page, Registered users on my website receive a 20 percent discount on CPE materials presented by myself and numerous other authors on a variety of professional topics.

My assistance in CPA firm quality-control consulting, audit planning, and peer-review preparation can be obtained by sending an email using the “Contact Us” tab on my home page.

Related article:

Clarified Auditing Standards: Audit Evidence – Part 1 (AU-C Section 500)


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