1.	Substantive Test Strategy Decisions
1.1.	Overview
The primary purpose of an audit is the expression of an opinion on whether the entity's financial statements are presented fairly, in all material respects, in conformity with generally-accepted accounting principles. The auditor needs a high level of assurance that the opinion is appropriate; that is, audit risk must be limited to a low level. Audit risk is the risk (comprising inherent and control risks) of the financial statements containing a material misstatement and the risk, known as detection risk, of the auditor not detecting a material misstatement in the financial statements.

The auditor
•	Identifies inherent risks associated with the entity
•	Assesses control risk as a basis for determining the audit strategy
•	Controls detection risk by performing substantive tests to gain the necessary assurance regarding the various assertions embodied in the financial statements

The audit strategy for each significant class of transactions or related account balance will depend on the auditor's judgment both about how effectively relevant controls are designed and operating and about whether it is more efficient to test the controls or to test the account balances themselves. The auditor may choose to obtain evidence entirely from substantive tests of account balances and transactions, but, as stated in Statement on Auditing Standards (SAS), AU Section 319.81, may not choose to omit substantive tests entirely for all of the assertions (and corresponding audit objectives) relevant to significant account balances or transaction classes. Substantive tests consist of analytical procedures and tests of details of account balances and related transactions. Generally, a combination of these procedures are performed in auditing a specific account balance or class of transactions.

Nature, Timing, and Extent of Substantive Tests

The nature, timing, and extent of the substantive tests to be performed to meet specific audit objectives for each account balance and class of transactions are determined by:

•	The type of account involved
•	The information about the entity obtained or updated for the purpose of making preliminary judgments about materiality and identifying inherent risks
•	The assessment of control risk
•	The auditor's judgment about the most efficient and effective combination of auditing procedures

Assessing how much assurance can be attained from a particular substantive test is a matter of professional judgment and cannot be specified without knowledge of the full context in which the test is to be performed. This course describes many substantive tests. Auditors rarely perform all of them on an engagement. Instead, after considering the evidence obtained from tests of controls and other risk assessment activities, an auditor selects the specific tests, for each audit objective relevant to each financial statement account and disclosure, that will provide the evidence necessary in the particular circumstances.

The key to selecting appropriate substantive tests is the auditor's understanding of management's assertions and the corresponding audit objectives. The auditor identifies specific audit objectives for each significant account balance and designs auditing procedures to provide the necessary assurance that those objectives have been achieved. Figure 1 illustrates the audit objectives that may be applicable to an entity's trade accounts receivable and sales. It provides examples (which are not intended to cover all circumstances) of substantive tests of details the auditor may perform to satisfy the objectives.

Figure
Audit Objectives for Trade Accounts Receivable and Sales

Objective	Specific Objective	Illustrative Substantive Tests of Details	
Complete-ness	Trade accounts receivable represent all amounts owed to the entity at the balance sheet date arising from sales transaction. 
All shipments made and services rendered during the period covered by the financial statements and all returns and allowances are reflected in the financial statements.	Compare records of goods shipped and services performed with recorded transactions.	
Accuracy	Sales transactions are based on correct prices and quantities and are accurately computed and classified in the appropriate general ledger and accounts receivable subsidiary ledger accounts. The accounts receivable subsidiary ledger is mathematically correct and agrees with the general ledger.	Compare amounts on shipping documents and invoices with supporting documents and recorded transactions. (Confirmation of customers' accounts to some extent also indicates the accuracy of the balances.) Using audit software, calculate invoice amounts and total the accounts receivable subsidiary ledger.	
Existence/
Occurrence	Recorded accounts receivable represent amounts owed to the entity at the balance sheet date. Recorded sales transactions represent goods actually shipped or services actually rendered during the period covered by the financial statements.	Confirm customers' accounts, investigate any discrepancies reported or questions raised, and determine whether any adjustments are necessary.	
Cutoff	Sales transactions, cash receipts, and returns and allowances are recorded in the proper period.	Perform cutoff tests:
(a) Determine that sales invoices are recorded as sales in the proper period by comparing the related records of goods shipped and services performed with recorded sales for several days before and after year-end.
(b) Determine that credit memos are recorded in the proper period by examining the related records of returns and claims from customers for several days before and after year-end.	
Valuation/
Allocation	Accounts receivable are stated at net realizable value (i.e., net of appropriate allowances for uncollectible accounts, discounts, returns, and similar items). Revenue is recognized only when appropriate accounting recognition and measurement criteria are met.	Determine whether the allowance for uncollectible accounts is adequate by reviewing the aged trial balances, discussing the allowance and composition of the receivable balance with management, and identifying significant old receivables and receivables in dispute or changes in the collectibility of current receivables. Review cash collections after the balance sheet date and examine related remittance advices or other supporting documentation to ascertain that payments relate to the balance that was due at the balance sheet date. Determine the adequacy of collateral. Review relevant credit file information. Discuss all significant potentially uncollectible accounts with management. Determine that revenue has been recognized in conformity with GAAP.	
Rights and Obligations	Accounts receivable are legal rights of the entity at the balance sheet date.	Make inquiries and read agreements relating to the possible sale of receivables that the entity continues to service.	
Presentation and Disclosure	Accounts receivable, sales, and related accounts are properly described and classified in the financial statements. Accounts receivable pledged as collateral are properly disclosed. Concentrations of credit risk arising from accounts receivable are properly disclosed.	Identify liens, security interest, and assets pledged as loan collateral by reviewing debt and lease agreements; confirmation replies, particularly from financial institutions; and minutes of directors' meetings. Inquire of management about those items and about concentrations of credit risk that need to be disclosed.	
1.2.	Types of Accounts
The nature, timing, and extent of substantive tests appropriate for a particular audit objective and account vary with the type of account. Accounts may be classified into three types:

1. Accounts that are derived from a major class of transactions within a transaction cycle that typically involves high volumes of transactions

Examples are cash, accounts receivable, inventory, accounts payable, purchases, salaries and wages, and sales. These are referred to in this course as systems-derived accounts. The transactions that generate these accounts are commonly subjected to control activities that address control objectives relating to processing transactions, maintaining files, and protecting assets. Decisions about whether the audit strategy for these accounts should include tests of controls generally are related to whether that would be the most efficient way to achieve the existence/occurrence, completeness, and accuracy audit objectives.

2. Accounts that reflect internal allocations of revenues or expenses over time through the accrual, deferral, or amortization of assets or liabilities

Examples of such accounts include accrued receivables and payables, deferred charges and credits, machinery and equipment, and asset valuation and estimated liability accounts. These accounts often require management to exercise judgment in determining the period or method of allocation and also in selecting and applying accounting measurement and recognition principles. While the transactions and accumulated data that form the basis for these accounts are sometimes subjected to control activities, it is usually more efficient not to test controls related to these accounts.

3. Accounts that typically reflect a relatively small number of material transactions in an accounting period

Examples of these accounts include long-term investments, bonds payable, land and buildings, and contributed capital accounts. Balances in these accounts often are carried forward unchanged from one year to the next. Because transactions affecting these accounts occur infrequently, control activities may not be established to address control objectives relating to processing transactions, maintaining files, and protecting assets. Even when the transactions affecting these accounts are subject to control activities, testing controls usually is not an efficient audit strategy.
Study Check 1 & 2
1.3.	Effect of Control Risk Assessment
The assessment of control risk affects the nature, timing, and extent of substantive tests directed at the existence/occurrence, completeness, and accuracy (and sometimes cutoff and valuation) audit objectives for account balances derived from transactions commonly subjected to control activities or monitoring controls that operate at the level of transaction cycles or classes of transactions (i.e., systems-derived accounts). In assessing control risk the auditor generally considers existence/occurrence, completeness, and accuracy together for the accounts within a particular transaction cycle. Based on the assessment of control risk, the auditor often is able to conclude that the risk of material misstatement, and therefore the level of assurance required from substantive tests, with respect to those objectives for systems-derived accounts is lower than for other audit objectives. This conclusion generally is based on the following:

•	Existence/occurrence, completeness, and accuracy often are addressed by controls whose operating effectiveness can be tested.
•	The fact that computer processing is not subject to random error further reduces the risk of material misstatement, particularly with respect to accuracy and, to a lesser extent, completeness.
•	Existence/occurrence, completeness, and accuracy normally are not affected by management's subjective judgments and estimates.

Although controls generally address the existence/occurrence objective, it is the audit objective most at risk with respect to fraud. Segregation of duties, physical controls, computer security controls, and controls over the authorization of transactions are particularly relevant to the existence/occurrence objective. Since management or employee fraud usually involves both deliberate circumvention of controls and an attempt to conceal the result, the auditor may need to perform substantive tests of details for existence/occurrence, regardless of the control risk assessment.

For accounts other than systems-derived accounts, control activities may not address the risks associated with existence/occurrence, completeness, and accuracy, although aspects of the control environment and accounting system may affect the achievement of those audit objectives. Even though an entity may have control activities to ensure a proper cutoff of purchases, sales, cash receipts, and cash disbursements, the auditor generally finds it more efficient not to test controls with respect to the cutoff objective but instead to obtain evidence primarily from substantive tests.

It usually is not possible to derive significant evidence from internal control in relation to the audit objectives of valuation, rights and obligations, and presentation and disclosure for any type of account. This is because those objectives generally are not addressed by control activities, although control activities may address the existence/occurrence, completeness, and accuracy of data that management uses in making valuation and disclosure judgments, such as annual depreciation of plant and equipment. Management's judgments and estimates that are related to the valuation, rights and obligations, and presentation and disclosure objectives, can be complex and may not be free from bias. Many entities do not have the professional expertise within their organization to deal completely with the many issues relating to these objectives. The impact of inherent risks and assessments of the control environment—notably the competence of financial accounting personnel and the quality of management reviews of financial information—are particularly relevant to these objectives. Even in large, well-managed entities, however, the auditor rarely is able to assess the risk of material misstatement with respect to valuation, rights and obligations, and presentation and disclosure at low and should always seek a high level of assurance from substantive tests directed to these objectives.
1.4.	Nature of Substantive Tests Under Varying Risk Assessments

Substantive Tests That Provide High Assurance

Assessing control risk at maximum for a specific audit objective for a particular account means that all audit assurance, within the context of materiality, will be derived from substantive tests, primarily tests of details. As noted above, that is often the only feasible or the most efficient audit strategy for all audit objectives for non-systems-derived accounts and for the valuation, rights and obligations, and presentation and disclosure audit objectives for systems-derived accounts. Assurance with respect to rights and obligations and the selection of accounting principles can be obtained only by considering the substance of specific transactions and other events and circumstances that affect the entity and the appropriateness of the accounting recognition, measurement, and disclosure principles that the entity has selected and applied to reflect them. While analytical procedures can be good detectors of changes in accounting principles, they will not alert the auditor to a misstatement resulting from an incorrect accounting principle that remains unchanged.

For accounts involving the accrual, deferral, or amortization of revenues and expenses, analytical procedures and reperformance of computations usually provide the necessary assurance about accuracy. Assurance about existence/occurrence and completeness with respect to transactions that give rise to those accounts usually is obtained, to the extent necessary, by means of substantive tests of details. For accounts involving balances that are carried forward from one year to the next, the auditor may obtain evidence regarding the existence/occurrence, completeness, and accuracy objectives by examining the details underlying the transactions in the accounts, reperforming calculations on selected transactions, and performing analytical procedures. Assurance with respect to existence for certain of those accounts may be obtained by confirmation or, in situations where the theft of assets is a significant risk, inspection of assets. In certain entities the recorded transactions that affect these accounts are subject to control activities; if so, the auditor should consider this fact as part of the risk assessment activities.

Substantive Tests That Provide Moderate to Low Assurance

For the existence/occurrence, completeness, and accuracy objectives (and sometimes cutoff and valuation) for systems-derived accounts, assessing control risk below the maximum makes it possible to restrict the substantive tests required to obtain the necessary audit assurance. For those audit objectives, substantive testing normally consists of a combination of analytical procedures and tests of details. Tests of details can generally be restricted to a level that provides low to moderate assurance. The level of assurance necessary will take into consideration inherent risks identified and will depend largely on the assessment of control risk; that is, whether it is closer to maximum or to low. If control risk is assessed toward the upper end of the continuum (closer to maximum), the auditor should seek to obtain moderate assurance from substantive tests of details. If control risk is assessed at the lower end of the continuum (closer to low), the auditor may restrict the level of substantive tests of details to provide low assurance. If it is effective and efficient to assess control risk at low for existence/occurrence, completeness, and accuracy for systems-derived accounts, the auditor may restrict substantive tests for those objectives and accounts mainly to appropriate analytical procedures.

Often the auditor determines that it is efficient to perform tests of details to obtain all necessary assurance about the cutoff objective, even if control activities address cutoff for systems-derived accounts, such as purchases, sales, cash receipts, and cash disbursements. Some entities, however, have well-designed cutoff controls, and in those instances it may be efficient to assess control risk below the maximum for the cutoff objective and perform a combination of tests of details and analytical procedures to obtain the necessary additional assurance. Furthermore, tests of transaction processing controls may also provide some evidence regarding the cutoff objective.

The Effect of Efficiency Considerations and Availability of Evidence on Decisions About Testing

In determining the nature of substantive tests, the auditor considers both the level of assurance required and the efficiency with which evidence can be obtained. While analytical procedures commonly provide an efficient means of obtaining assurance, tests of details, although often less efficient, typically provide a higher level of assurance. In designing and performing substantive tests the auditor should consider the relationship among accounts and the likelihood that evidence obtained about one or more audit objectives with respect to a particular account balance or class of transactions may also provide assurance about other account balances or classes of transactions.

When designing substantive tests, the auditor should consider the information available within the entity and the reviews and other procedures that management performs. For example, management often uses key performance indicators and budgetary and other operating information to monitor the entity's operations. Management's review of this information may disclose potential material misstatements in the financial statements, may provide evidence of the effectiveness of the accounting system and control activities, and may be useful in designing substantive tests.

Entity personnel typically perform procedures at year-end, for purposes of financial statement preparation that are not performed at other times during the year. Examples of such procedures are periodic or cycle inventory counts, preparation of year-end accruals, and comparisons with third-party evidence, such as comparing loans with loan certificates, reconciliations of cash, or reconciliations of suppliers' statements. When considering the risk of financial statement misstatement and designing substantive tests, the auditor should also consider any special controls management may have instituted over these procedures. However, misstatement amounts experienced in prior years may not be indicative of current conditions unless the processing procedures and specially instituted controls have remained in effect from one year to the next. For example, an entity that does not maintain a perpetual inventory system may price its inventory at year-end based on recent purchases (first-in, first-out basis). Without assessing special activities relating to the pricing of inventory, the auditor would have no basis for concluding that the current year's inventory pricing does not contain a material misstatement, regardless of prior year experience.

Understanding how accounting procedures and, in some cases, related control activities affect an account balance usually helps in designing substantive tests. The auditor may have obtained this information with respect to systems-derived accounts when obtaining an understanding of the entity's internal control and should consider the need to obtain such an understanding for other accounts as well. For instance, the auditor may obtain an understanding of the prepaid insurance account through inquiry, and might test a few transactions to corroborate the responses to the inquiry; those tests would also provide evidence of a substantive nature. The results of these procedures would determine whether further substantive tests were necessary; whether they should be analytical procedures, tests of details, or both; and their extent.
Study Check 3 & 4
1.5.	Tests of Income Statement Accounts
Auditors have traditionally focused more on audit objectives related to balance sheet accounts than on income statement accounts, for both practical and conceptual reasons. Frequently, that is the most efficient and conceptually sound way to conduct an audit. For some systems-derived income statement accounts, tests of details directed at an audit objective for a balance sheet account may provide the necessary assurance regarding the same audit objective for the related income statement account. For example, tests of details directed at completeness of accounts receivable may include matching shipping documents with invoices, and eventually with entries in the general ledger. These tests also provide assurance regarding the completeness of revenue. However, the auditor should consider whether the extent of testing, which in this example was designed to test the balance sheet account, also satisfies the income statement account. If not, the auditor may extend the tests of details or perform an analytical procedure directed at revenue to obtain the necessary additional assurance.

Many income statement accounts are related to balance sheet accounts and may be audited as described above. Examples include purchases/accounts payable, provision for bad debts/allowance for doubtful accounts, insurance expense/prepaid insurance, and interest expense/accrued interest. Some income statement accounts are directly related to other income statement accounts and may be effectively audited by performing analytical procedures. For instance, there is often a direct relationship between sales commissions and revenue. Still other income statement accounts are not directly related to other accounts, either in the balance sheet or the income statement, such as legal expense, and, if material, should be audited by tests of details.
Unit Review
2.	Techniques, Timing, and Extent of Substantive Tests of Details
2.1.	Techniques Used to Perform Tests of Details
Substantive tests of details of transactions and account balances, or of other information in the financial statements, normally involve the techniques of inquiry, observation, examining documents and records, reperformance, inspecting assets, and confirmation. The following paragraphs describe each of these and suggest how they relate to the seven audit objectives.

Inquiry

Frequently, one of the auditor's first steps in testing an account balance or class of transactions is to make inquiries of entity management and employees; the responses are then corroborated by other tests. At various stages in the audit, discussions with management or employees and subsequent follow-up may bring errors to the auditor's attention. For example, the auditor inquires about management's plans as part of considering the entity's ability to continue as a going concern. In addition, the auditor obtains letters from the entity's lawyers regarding legal matters, and letters of representation from management concerning, among other matters, the recording of known liabilities, the existence of contingent liabilities, and the existence and carrying value of inventory. Inquiries may provide evidence about many audit objectives, depending on the specific accounts or transactions involved. Lawyers' and management representation letters provide assurance relating to rights and obligations, and presentation and disclosure. 

Observation

The auditor may observe the entity's employees as they perform various tasks, like counting inventory. The auditor's observation of how the entity conducts a physical inventory can provide firsthand knowledge of the accuracy and completeness of the inventory count.

Examination

The auditor often examines documents or records supporting a transaction or item in the financial statements. Depending on the direction of a test involving examining documentation, the test may provide assurance that either recorded transactions occurred and related assets or liabilities exist (existence/occurrence), or that all transactions that occurred were recorded (completeness). For instance, the auditor may select particular accounts payable and examine the underlying purchase orders, invoices, and receiving reports to determine that recorded accounts payable are for items that were ordered and received. Examining documentation supporting recorded amounts is a test for existence/occurrence, and is sometimes known as vouching. Going in the opposite direction, the auditor may select shipping documents, compare them with the related sales invoices, and compare the details on those documents with entries in the sales journal and general ledger. The purpose of that test would be to obtain assurance about completeness, that is, that all goods shipped were billed and recorded. Examining documents which indicate that transactions have occurred and determining that the transactions have been recorded in the accounts is sometimes known as tracing. Examining documentation related to transactions recorded shortly before and after the entity's year-end provides assurance about the cutoff objective. The auditor normally examines documents to obtain evidence that employees have performed all prescribed procedures, reperforms those procedures (on a test basis, if appropriate), and determines that no aspects of the transaction appear unreasonable (such as a supplier's invoice not addressed to the entity). That evidence may have been generated wholly or partly outside the entity (such as suppliers' invoices, customers' orders, signed contracts) or by the entity itself (such as purchase orders, receiving reports, marketing plans). If external evidence is available, it is usually considered more reliable than internal evidence.

If entity personnel compare accounting records with physical assets, such as inventory, or with documents, such as invoices, the auditor may be able to use these comparisons and their documentation in performing substantive tests. That is, the auditor may choose to test the entity's matching procedures, which is what typically happens during the physical inventory count, rather than perform similar or duplicative procedures. If the entity's internal control includes supervision or reviews of those comparisons, the auditor, as part of the substantive tests, may examine the documentation of those monitoring controls to obtain evidence that they operated effectively (alternatively, the auditor may have done this in assessing control risk). For example, the auditor's tests of the physical inventory count would ordinarily include tests of the activities of personnel who supervise the employees who do the actual counting. In addition, management's review of reports, which is an aspect of monitoring that the auditor often tests in assessing control risk, also can serve as the basis for a substantive test, depending on the type of report involved. For instance, management's review of reports of write-offs or dispositions of obsolete inventory could be one source of evidence that the financial statements do not reflect inventory carried at more than its net realizable value.

One specific form of internal documentation that the auditor reads at various stages in the audit is minutes of meetings of the board of directors and its important committees. Reading the minutes enables the auditor to examine the board's approval of the significant corporate actions for which such approval is required and to determine whether significant decisions that affect the basic financial statements or require disclosure in the notes have been dealt with properly. The auditor should be satisfied that management has provided copies of minutes of all meetings held during the period, including meetings held after year-end but prior to the report date.

Reperformance

The auditor may reperform, usually on a test basis, procedures performed by employees, primarily to determine that a transaction was accurately accounted for. Reperformance of computations, such as of a reconciliation, also provides some assurance about the existence of the account balance (in the case of a reconciliation, cash). Many account balances represent the result of a computation or an accumulation of computations. To substantiate the accuracy of such an account balance, the auditor often reperforms some or all of the detailed computations or otherwise makes an overall evaluation of the balance. If judgment is the basis of a computation, such as in the valuation of accounts receivable, the auditor reperforming the computation should also understand and evaluate the reasoning process underlying the judgment. For example, if the provision for uncollectible accounts is based on a formula (giving appropriate consideration to past experience) related to the age of the receivables, the auditor should consider the reasonableness of the formula as well as reperform the mathematical calculations. (The auditor would also perform other procedures regarding the collectibility of accounts receivable in reviewing the adequacy of the provision for uncollectible accounts.)

Inspection

Inspecting assets involves counting or examining physical items represented by accounts in the financial statements. A typical example of inspection, combined with observation, is the tests of employees' counting procedures and recounting of some of the counts during a physical inventory. Other items subject to inspection (which the auditor may count or examine directly) include cash, marketable securities, and property, plant, and equipment. Inspecting assets is a principal source of assurance about their existence and about the accuracy of the related accounts. It may provide some assurance about completeness that all items counted were recorded, and about valuation, that inventory is not obsolete.

Confirmation

Confirmation consists of obtaining and evaluating a direct communication from a third party in response to a request for information about a specific item affecting one or more financial statement assertions. Evidence obtained from sources independent of the entity usually is more reliable than that from parties within the entity. For example, if the auditor seeks greater assurance about a financial statement assertion from substantive tests because the assessed level of control risk is at or close to maximum, or because a transaction is unusual or complex, he or she is likely to request confirmations from outside parties instead of, or in addition to, examining documents or making inquiries of entity personnel. Although confirmations may provide assurance relating to any of the audit objectives, they do not address all objectives equally well. In general, and depending on their design, confirmations tend to be more effective in providing evidence about existence/occurrence, rights and obligations, and, to a somewhat lesser extent, accuracy and cutoff, than about valuation and completeness.

Confirmation requests should be tailored to specific audit objectives, circumstances, information sought, and respondents. In designing confirmation requests, the auditor should consider the types of information respondents can be expected to be able to confirm, which is largely a function of their accounting and information systems. For instance, a customer may not be able to confirm the total balance owed, but may be able to confirm individual transactions. To determine what information is relevant to the purpose of the confirmation, the auditor needs to understand the entity's transactions; often details of transactions can be confirmed in addition to amounts. Confirmation requests should be directed to individuals who are believed to be knowledgeable about the specific items to be confirmed. For instance, if an auditor seeks to confirm the terms of and balances outstanding under a major contract between the entity and a supplier, the confirmation request might be addressed to the executive handling the entity's account.

Many substantive tests of the details of transactions and account balances involve procedures, such as examining documents or reperforming calculations, that are the same as the procedures used in testing controls. This is not surprising; whether a particular procedure is a test of controls or a substantive test depends not on the procedure itself, but on the purpose for which it is performed. For example, reviewing the entity's bank reconciliation could be a test of entity personnel's performance of periodic reconciliations of the cash account (a test of controls); the auditor's reconciliation at year-end would be a substantive test of the accuracy and existence of the cash balance. As a general rule, tests of details of transactions that are subject to controls are tests of controls; tests of details of ending balances of balance sheet accounts are substantive tests. Regardless of the purpose of a particular test, however, many tests provide evidence that serves the other purpose as well.
Study Check 5 & 6
2.2.	Timing of Tests of Details
It is often desirable to perform tests of details before year-end (early substantive testing), particularly if management wants the audit to be completed shortly after year-end. This may be done in appropriate circumstances without impairing the effectiveness of the audit, although before doing so the auditor should assess the difficulty of controlling the incremental audit risk. 

If early substantive testing is done, the auditor will have to obtain satisfaction that, for the balances tested early, the risk of material misstatement is low during the intervening period between the early testing date and year-end. Generally, the auditor obtains that satisfaction by testing relevant controls during the intervening period. Such tests of controls might include reviewing reconciliations of individual ledger balances to control accounts and investigating any unusual items in the reconciliations. The auditor should also perform analytical and other substantive procedures, as described later, to obtain assurance about the recording of transactions during the intervening period.

In certain circumstances, the auditor might obtain satisfaction about transactions during the intervening period by examining evidence of the operation of special controls in effect for that period. As an example, management's review of sales transactions recorded around year-end, performed to ensure a proper cutoff, also would provide some evidence about the existence and accuracy of sales recorded after an early accounts receivable confirmation.

If the auditor performs early substantive testing, the balances tested early should be linked to year-end balances by one or more of the following procedures, as appropriate in light of the assessment of control risk:

•	Reviewing key performance indicators and management information for unexpected variations in account balances at the balance sheet date, and investigating any material fluctuations in account balances and any unusual activity since the time of the early substantive tests
•	Scanning entries in the relevant general ledger accounts (including control accounts) or reviewing summaries of recorded transactions to determine whether any expected entries have been omitted and whether the entries appear to be reasonable in relation to the normal level of activity
•	Reviewing any special activities the entity has carried out on the year-end figures
•	Reviewing reconciliations of individual ledger balances to control accounts, and investigating any unusual items in the reconciliations
•	Ensuring that any relevant matters brought forward from the early substantive testing date have been satisfactorily resolved
•	Reassessing any valuation accounts (e.g., allowance for uncollectible accounts) in light of the latest available information

In most instances, early substantive testing is not appropriate unless the auditor has obtained evidence, through tests of controls, that controls related to transactions and account balances tested early are effective, that is, unless control risk has been assessed below the maximum or at low. In addition, early substantive testing is usually not done for all assertions relating to an account balance. For example, the existence of accounts receivable may be confirmed at an early date, but their valuation tested at year-end. In particular, if control activities necessary to protect assets (such as inventories) from theft are ineffective, early substantive testing (such as observing early physical inventory counts) normally is not appropriate, because the auditor will be unable to obtain evidence that those assets were protected in the intervening period, and will therefore not have evidence about their existence at year-end.

Significant changes in the entity's circumstances after the date of early substantive testing may require the auditor to perform additional procedures. To avoid unnecessary work, the auditor should consider the possibility of such changes when determining the auditing procedures to be performed. AU Section 313 contains the authoritative guidance on performing substantive tests before the balance sheet date.
2.3.	Extent of Testing
An audit should not try to embrace a complete verification of all the transactions of the period under review. If for every procedure the auditor selected for obtaining evidence, or if for even a few of those procedures, he or she were to examine every item that could possibly be selected for examination, it would be virtually impossible to complete an audit on a timely basis, not to mention at a reasonable cost. Neither the entity's management nor the public expects the auditor to examine every transaction. Consequently, the auditor is continually faced with the question: How much testing is enough?

The auditor's preliminary judgments about materiality and the assessment of control risk are the primary factors in determining the extent of substantive testing. If the auditor seeks a low level of assurance about an account balance (that is, is willing to accept a relatively high level of detection risk), substantive tests might consist solely of analytical procedures, limited substantive tests of details, or a combination of the two. The limited substantive tests of details might, for example, consist of examining one or a few items in the account balance, the purpose of which would be to confirm the risk assessment.

Some tests of details, such as a recomputation of an accrued liability, cannot be applied to less than an entire account balance. In addition, other accounts, because of their nature, are usually completely examined. For example, in performing a bank reconciliation, the auditor tests all of the details (e.g., all outstanding checks). Also, the auditor confirms with the stock transfer agent all shares of stock issued and outstanding. In other cases, the efficiency and effectiveness of audit testing can be increased by selecting certain items or accounts for 100 percent examination because of the high risk of material misstatement. For instance, in testing the accrual for executive vacation pay that the president's secretary computed, the auditor might recompute each executive's pay.

In many instances, however, it may not be efficient to subject all items that make up an account balance or class of transactions to substantive tests of details. When an auditing procedure will be applied to less than 100 percent of the population of an account balance or class of transactions, the auditor faces a choice about which method to use in determining the items to be examined: high-value testing, "accept-reject" testing, or sampling.

High-Value Testing

In high-value testing, an auditor examines sufficient items with high-dollar values in an account balance or class of transactions so that the remaining amount is immaterial and need not be tested. Alternatively, the risk of material misstatement in the items not included in the high-value testing may be reduced to a low level by using other auditing procedures; for example, analytical procedures using scanning techniques or sampling. For instance, if accounts receivable consisted of six accounts aggregating 85 percent of the account balance and 50 accounts making up the remaining 15 percent, the auditor might confirm all six high-value accounts positively and apply analytical procedures to the account as a whole or scan the portion not tested. The working papers should document the auditor's planning considerations in high-value testing, the procedures performed, and the results of and conclusions drawn from the tests.

Accept–Reject Testing

In some situations, an auditor may use a testing method known as accept-reject testing. While this method is similar to sampling in some respects, it differs from sampling in that sampling involves the projection of a misstatement amount, while accept–reject testing does not. In place of projection, the auditor either "accepts" that the test objective has been achieved because the test yields no or negligible misstatements, or "rejects" the test because it yields more than negligible misstatements. If the test is "rejected," additional audit testing is carried out (after ensuring that the source of the misstatement has been identified and the account has been adjusted) to achieve the test objective. Following are some examples of accept–reject applications when the projection of a misstatement amount is not practicable:

•	The addition of a listing of accounts receivable may be tested by adding only certain pages. If no misstatements are found, the auditor may accept the test and conclude that the account balance is accurately totaled. On the other hand, if a misstatement is found, the auditor normally rejects the account balance and asks entity personnel to retotal it.
•	A population of bank reconciliations may be accepted or rejected on the basis of testing only some of the reconciliations. Projecting a dollar amount of misstatement to a population of bank reconciliations would be meaningless, as would projecting a misstatement amount in addition on one page in a listing to the entire listing.
•	In performing substantive tests of inventory counts, the auditor may make test counts of the various count teams and would likely accept the work of count teams that produced accurate counts. If a team's counting was found to be inaccurate, the auditor might reject its work and require the area that team counted to be entirely recounted.

If misstatements are detected through the application of such procedures, the auditor is unlikely to be able to project the misstatements to the entire population, and as a result generally changes either the nature or the extent of the planned auditing procedures to obtain the required assurance about the entire population.

The working papers should document the auditor's planning considerations in accept–reject testing, the methods by which the items to be tested were selected, and the conclusions drawn from the tests.

Sampling

In sampling, an auditor projects a misstatement amount to the entire account balance or class of transactions from which the sample was selected, in order to form a conclusion about the population. Whether sampling is appropriate depends on the objective of the test, the technique that best achieves that objective, and the level of assurance required from the test. The auditor usually makes the decision to use sampling as a basis for selecting and evaluating evidence after specific auditing procedures have been selected for use in obtaining evidence. For example, the decision to examine vendor invoices to obtain assurance about the existence and accuracy of accounts payable usually precedes the decision to use sampling to select the invoices for examination.

The following are examples of substantive tests that often involve sampling:

•	Selecting accounts receivable balances or transactions for confirmation
•	Selecting accounts payable balances or transactions for the purpose of examining underlying documentation, and reperforming calculations to establish the existence and accuracy of accounts payable
•	Price-testing selected inventory items to establish the accuracy of cost or valuation at the lower of cost or market
•	Selecting and independently counting items from the entity's perpetual inventory records for the purpose of testing the existence and accuracy of the inventory quantities (where the entity carries out cycle counts of inventory items and makes necessary adjustments to the perpetual records)

In developing a sample, the auditor considers the level of assurance required from the test. Statement on Auditing Standards (SAS) No. 39, Audit Sampling, (AU Section 350), includes a model that demonstrates mathematically what auditors know intuitively: As more assurance is obtained from one source, less assurance is required from other sources. The model also allows the auditor to express levels of assurance numerically, which may be useful as a confirmation of the thought process in designing substantive tests, including those using sampling, to obtain the required level of assurance. If control risk has been assessed below the maximum but not at low, the level of assurance required from substantive tests can usually be obtained from a combination of analytical procedures and tests of details, often using sampling. The level of assurance sought from the sampling application, and thus its design, depend on where along the below-the-maximum continuum the risk assessment falls and the nature and results of any analytical procedures performed. The model also demonstrates how a small change in one of these factors, such as the level of assurance obtained from analytical procedures, has a significant effect on the design of the sample that will be needed. This points to the need to consider cost–benefit relationships when determining the nature and extent of substantive tests, including analytical procedures.
Study Check 7
Unit Review
3.	Computer Techniques and Programmed Procedures
3.1.	Using Computer Audit Techniques to Perform Substantive Tests
In a computerized system, an auditor can perform many substantive tests most efficiently using audit software. Auditing with the computer can increase efficiency by mechanizing auditing procedures and enabling the auditor to test large numbers of transactions. Software is available, or the auditor can develop it, to test transactions, master file and reference data, historical data, programs, and activity logs—in fact, almost any information that is stored in a computerized system. The auditor also can perform various auditing procedures—including analytical procedures and tests of details—with the help of audit software designed specifically for that purpose.

The auditor can use the same software tools in more than one testing technique; in certain circumstances these tools also can be used in performing tests of controls. Sometimes a combination of different types of software is required to meet a single audit objective. Audit software can assist in calculating, summarizing, selecting, sorting, comparing data, and producing reports to the auditor's specifications. Sometimes, such as when an auditor uses generalized audit software packages, the same software can access and process data. For example, the auditor can use software to examine all data on a file, to identify data that meets a particular condition (e.g., a total of debtors' balances that exceed their credit limits), and to print out selected data, like the results of tests or items selected for investigation.

Software tools that the auditor can use to access and process data include generalized audit software packages, application audit software packages, customized audit software, inquiry programs, report generators, and other system utility software and service aids. These tools are discussed in the following paragraphs.

Generalized Audit Software Packages

The most widely used computer-assisted audit techniques employ generalized software packages specifically designed for audit purposes. Audit tasks performed on entity files include totaling a file, identifying exceptions, selecting items for manual review, and formatting reports. Generalized audit software helps the auditor carry out those tasks on a variety of files at different installations. Its use eliminates much of the work involved in writing individual computer programs to accomplish those functions.

To use audit software, the auditor defines what computer configuration the program is to be run on and which files to use. Simplified procedural statements or parameters control the program logic. The software normally has special functions to facilitate using the program to generate the kind of audit evidence and documentation desired. These include report formatting (page numbering, page breaking, column placement, and headings), totaling and subtotaling data, automatic production of processing statistics (number of records read and processed, and number of positive, negative, and zero-value records), and sorting and summarizing data.

Whenever the auditor uses the entity's data files in performing tests, the files should be backed up so that the entity's data cannot be lost or altered inadvertently. In general, it is not advisable to use the entity's "live" production files in audit testing for that and other reasons. It is preferable to use copies of such files, outside of the normal processing cycle, or dummy transactions that are readily identifiable and easy to remove.

Generalized audit software packages permit programs for specific applications to be developed in a relatively short time by people with limited programming skills. The use of generalized packages also reduces the auditor's reliance on the entity's staff, although their assistance is usually required to install the package and develop instructions to operate it. The main disadvantage of generalized packages is that there are usually limitations on the number and structure of files that the user can access. Often the auditor can overcome those limitations by using a generalized audit software package in combination with customized software or utilities.

Application Audit Software Packages

Certain auditing procedures and requirements are so similar from one audit to another that the same programs can be applied with only minor changes, even though the data files vary. Some auditing firms have developed application audit software packages to achieve common audit objectives in several areas, like accounts receivable, accounts payable, and payroll. For instance, an auditor may use application audit software to analyze the accounts receivable ledger by age, select items for audit testing, produce confirmation letters, and match subsequent collections received. To run the software, the auditor converts the data files into a compatible format, determines the appropriate parameters, and executes the software. Some audit tests are unique to certain industries and to applications within those industries; some firms have also developed packages for these specialized areas.

Customized Audit Software

Although generalized and application software packages are useful in many situations, the auditor may need to develop customized software for special needs. For example, software packages may not be available for the entity's computer, the output required may be very specialized, or the computations and data handling may be particularly intricate. In those circumstances, the auditor may use the computer languages available on the entity's system to develop customized audit software. In addition, many generalized audit software packages allow the integration of additional routines into the software, affording increased flexibility and wider applicability.

Inquiry Programs

When available, standard data inquiry (or interrogation) programs, which extract or display data without updating or otherwise changing it, can be economical audit tools. Relatively simple interrogation methods exist for many smaller computers, and are often built into larger database management systems. A disadvantage of using inquiry programs is that they are often unique to a particular computer or database, which means that the auditor will have to read manuals and learn the particular program.

Report Generators

Report generators are versatile utilities that auditors can use to obtain data from the system in specified forms that meet their specific needs. These utilities can generate a variety of reports, including reports on database contents. A major advantage of report generators is that the auditor can request data initially and then progressively refine the request, focusing on more specific areas of interest. Report generators were originally designed to report on system functions, though auditors can also use them in this way to produce listings of system privileges and similar data.

Systems Utility Software and Service Aids

Computer manufacturers and software vendors provide systems utilities and service aids to perform limited, predefined tasks. Utilities and service aids are normally used to enhance system functioning or for programming. Utilities may be necessary to set up and execute computerized auditing procedures. Some utilities can substitute for procedures that generalized audit software or specially written programs would otherwise perform. The auditor can use utilities to examine processing activity, interrogate data, and test programs and operational procedures. For example, one utility can copy and rearrange sequential files; another can extract particular records from one file and create a subset file for audit testing.
Study Check 9
3.2.	Substantive Tests of Programmed Accounting Procedures
If the auditor needs evidence of the effective operation of programmed accounting procedures, it can be obtained by testing those procedures directly throughout the period, generally using various types of audit software. (In certain circumstances, manual techniques are appropriate, as discussed later.) However, testing specific programmed procedures is costly and the auditor usually chooses an alternative audit strategy. Therefore, only a brief description of some of the techniques used for testing programs is presented here.

Flowcharting Programs

This software helps the auditor understand the programmed procedures by producing flowcharts and other documentation of the program under analysis. Lists of commands and data names in the program can be generated and are often helpful in program code analysis (described below).

Program Tracing and Mapping

These techniques involve processing test data through application programs and are used primarily by programmers when developing and testing programs. Program tracing identifies the actual steps executed; program mapping identifies any unexecuted program instructions. Auditors use these techniques only occasionally because of the technical skills needed to analyze the results.

Program Code Analysis

This technique involves analyzing computer programs. Its main purpose is to confirm the existence of programmed procedures in a program or series of programs. Program analysis consists of:

•	[:BULLET:]Identifying the program to be examined by reference to the entity's documentation
•	[:BULLET:]Selecting the form of code to be examined, which is normally the source code. The auditor must know the programming language and make sure that the source version examined is the same version as the production program in use.
•	[:BULLET:]Analyzing the selected coding. It is usually difficult to follow another person's coding, but adherence to programming standards may simplify this task. Software aids, such as flowcharting programs, can produce additional documentation. In subsequent periods, comparison programs can be used to indicate changes.

Test Data and Integrated Test Facility

The test data method tests the entity's transaction processing controls. The audit software tools discussed earlier test actual entity data; in the test data method, entity programs process test data. The output of the processing is then compared with predetermined results.

There are two methods of running test data:

1. Test data can be processed using the entity's operational programs (but separately from the entity's data), using either copies of master files or dummy files set up for testing purposes.
2. Test data can be included in the entity's regular data processing, with a manager's approval.

The latter method is referred to as an Integrated Test Facility (ITF). If specific records on the master files are reserved or created for this purpose and consistently processed during testing at regularly established intervals, an ITF is also referred to as "Base Case System Evaluation."

Manual Testing

The auditor can use manual techniques for testing programmed procedures if adequate visible evidence is available. Data that must be tested to test the programmed procedures can be voluminous, however, making manual testing techniques impractical and inefficient. Although some visible evidence of the operation of programmed procedures is usually available, the results of processing are rarely printed out in detail. Instead, totals and analyses are printed out without supporting details, thus rendering it impossible for the auditor to determine the correctness of a total or an analysis. Exception reports and rejection listings that are produced do not provide evidence that all items that should have been reported or rejected were properly treated. In those instances, the auditor can request and sometimes obtain reports generated specifically to meet audit needs.

Sometimes visible evidence that the system does not readily provide can be recreated. Methods to achieve this are known collectively as "manual simulation techniques" and include:

•	Reassembling processed data into the same condition that existed when the programmed procedure was applied (e.g., reassembling batches of sales invoices to test the batch totals posted to the sales ledger control account)
•	Using current data before computer processing (e.g., testing the additions of batches before they are sent for processing, to determine that accurate batch totals are established to control subsequent processing)
•	Selecting a small number of items from those submitted for processing and processing them in a separate run (e.g., splitting a batch into two batches, one large and one small, processing the small batch separately, and agreeing the resulting computer-produced total to manually precalculated results)
•	Simulating a condition that will produce a report if the programmed procedure is working properly (e.g., altering a batch total to an incorrect figure so that the batch should be rejected, or withholding a document to see whether it is reported as missing); this approach requires careful planning and coordination with user departments
•	Requesting a special printout of items processed (e.g., a listing of sales invoices included in a sales total produced by the computer)

Manual tests cannot be performed if visible evidence of the operation of a programmed procedure neither exists nor can be produced, and the appropriate condition cannot be simulated. This often occurs in systems where transactions are entered directly through terminals without source documents.
Study Check 11
Unit Review
4.	Analytical Procedures
4.1.	Overview
Analytical procedures are an integral part of the audit process. They are reasonableness tests of account balances and classes of transactions that, as stated in SAS No. 56, analytical procedures, "consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data." Examples of analytical procedures routinely performed in an audit include fluctuation analyses, ratio analyses, comparisons of financial statements, and scanning accounting records for unusual entries or entries that do not meet the auditor's expectations. SAS No. 56 requires analytical procedures to be used in the planning and overall review stages of the audit, and encourages their use as substantive tests to provide assurance with respect to specific audit objectives for particular account balances or classes of transactions. Analytical procedures, together with tests of controls, and substantive tests of details of transactions and balances, provide the evidential matter required by the third standard of fieldwork.
4.2.	Developing Expectations
The basic premise underlying analytical procedures is that relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary. Examples of those conditions include specific unusual transactions or events, accounting changes, business changes, random fluctuations, and errors or fraud. Changes in relationships among data in the absence of conditions known to the auditor could suggest that the financial statements were misstated because of unknown errors or fraud.

In performing analytical procedures, the auditor first develops expectations of recorded amounts or ratios derived there from by considering plausible relationships among data. The bases for the auditor's expectations are knowledge obtained about the entity's business, the industry in which it operates, and inherent risks related to the entity broadly and to its specific account balances and classes of transactions. The auditor then compares the expectations with the recorded amounts or ratios. The comparisons may be simple or complex, and may involve single or multiple relationships.

Typically, the auditor uses the following sources of information, either individually or in combination, in developing expectations:

•	Financial information of comparable prior periods, adjusted for known current changes. For example, an expectation of current year's sales might be formed from the prior period's sales adjusted for known price and volume increases. That expectation would then be compared with the current period's recorded sales.
•	Anticipated results. For instance, an auditor could develop expectations from budgets, forecasts, and extrapolations of interim results, which would then be compared with recorded results.
•	Relationships among elements of financial information within the period. For example, an expectation of commission expense in relation to sales could be developed from an auditor's knowledge of the entity's commission policies and then compared with the relationship between recorded commission expense and recorded sales.
•	Information regarding the industry in which the entity operates. For instance, expectations of gross margins could be developed from industry-wide statistics for particular product lines.
•	Relationships between financial information and relevant nonfinancial information. For example, an auditor might develop expectations concerning available square footage related to revenue in a retail operation, labor hours related to labor costs, average rent related to rent revenue, or number of properties related to real estate tax expense.

Unexpected relationships or other items that appear to be unusual should be investigated if the auditor believes they indicate matters that may have implications for the audit. In investigating unusual items, the auditor generally considers them in light of the information obtained about the entity and its business, and makes inquiries of management. The auditor then seeks additional evidence to corroborate management's replies. Analytical procedures are effective only if the auditor exercises skepticism in evaluating management's explanations of unexpected results and seeks relevant and reliable evidence to support those explanations.
4.3.	Using Analytical Procedures to Achieve Audit Objectives
A major decision the auditor makes in designing substantive tests is whether to perform an analytical procedure, a test of details, or a combination of the two. That decision is based on the auditor's judgment about the expected effectiveness and efficiency of available procedures, considering the total assurance sought from substantive tests with respect to a specific audit objective for a particular account balance or class of transactions. In many situations, it is possible to design analytical procedures that, when considered in combination with other auditing procedures, will provide relatively high levels of assurance, so that the auditor will need less assurance from other substantive tests. In designing and performing both analytical procedures and tests of details, the auditor should consider the relationship among accounts and the likelihood that evidence obtained about one or more audit objectives with respect to a particular account balance or class of transactions also may provide assurance about other account balances or classes of transactions.

The effectiveness and efficiency of an analytical procedure in identifying potential errors or fraud depends on, among other things, (a) the plausibility and predictability of the relationship among the data analyzed, (b) the availability and reliability of the data used to develop the expectation, (c) the precision of the expectation, and (d) the nature of the account balances or classes of transactions and the particular audit objectives.

Plausibility and Predictability of the Relationship

It is important for the auditor to understand what makes relationships among data plausible. Data sets sometimes appear to be related when they are not, which could lead the auditor to erroneous conclusions. Relationships in a stable environment are usually more predictable than relationships in a dynamic or unstable environment. Relationships among income statement accounts tend to be more predictable since they represent transactions over a period of time, whereas relationships among balance sheet accounts tend to be less predictable because a balance at a point in time may be subject to many random influences. Relationships involving transactions subject to management discretion are usually less predictable; for example, management may influence the timing of maintenance or advertising expenditures.

Availability and Reliability of the Data used to Develop the Expectation

The availability of the necessary data to develop expectations for a particular assertion will vary. SAS No. 56 notes, as an example, that for some entities expected sales might be developed from production statistics or from square feet of selling space as a means of testing the completeness of sales. For other entities, however, data relevant to that assertion may not be readily available, and it may be more effective or efficient to perform substantive tests of details on the entity's shipping records.

The auditor should also consider whether the underlying financial and nonfinancial data used to develop the expectation is reliable. In considering the likelihood of misstatements in such data, the auditor considers, among other things, knowledge obtained during previous audits, the assessment of control risk, and the results of tests of details of account balances and transactions. The reliability of data used in an analytical procedure depends upon how much assurance the auditor desires from the procedure. For instance, in analytical procedures used in planning the audit, untested industry data may be appropriate for developing an expectation about the level of business activity. Expectations developed using information from a variety of independent sources may be more reliable than expectations developed using data from a single source.

Precision of the Expectation

The precision of the expectation depends on, among other things, how thoroughly the auditor considers the factors that affect the amount being audited, and the level of detail of the data used to develop the expectation.

Many factors affect financial relationships. Prices, volume, and product mix may affect sales, each of which, in turn, may be affected by a number of factors. In developing expectations, the auditor should consider the factors that might have a significant impact on the relationship. The more assurance desired from analytical procedures, the more thoroughly the auditor should consider factors affecting the relationship.

Analytical procedures based on expectations developed at a more detailed level have a greater chance of detecting misstatements of a given amount—and thus provide greater assurance—than do broader comparisons. Comparisons of monthly amounts may be more effective than those of annual amounts, and comparisons by location or lines of business may be more effective than entity-wide comparisons. What level of detail is appropriate may be influenced by the nature of the entity, its size and complexity, and the level of detail available in its records. Generally, the possibility that offsetting factors could obscure material misstatements increases as an entity's operations become more complex and more diversified. For example, the auditor's expectations regarding profit margins on sales in a diversified business will be more precise if they are based on an analysis using disaggregated data, such as gross profit margin by facility or product line, rather than on an analysis of the consolidated gross profit margin.

Nature of the Account Balance and Audit Objective

For some accounts, analytical procedures may be the most effective means for achieving certain audit objectives and may sometimes be the only procedure performed. For example, in some situations, two common analytical procedures, comparing the allowance for uncollectible accounts as a percentage of accounts receivable and as a percentage of overdue receivables with expectations developed from similar percentages for prior years, might provide sufficient evidence with respect to the valuation objective for accounts receivable. (In other situations, some substantive tests of details, such as investigating specific overdue items, might also be done.) Or, in auditing accrued payroll at year-end, the auditor may test the reasonableness of the accrual by multiplying the gross pay for the weekly, semimonthly, and monthly payrolls by the ratio of days accrued at year-end to the total number of days for the pay periods. Analytical procedures may be particularly effective when potential misstatements would not be detectable by examining details of transactions, especially when the relevant audit objective is the completeness of recorded transactions. Analytical procedures are commonly directed at revenue because of the significance of that account and its relationships to other income statement accounts.

On the other hand, examining documentation (a test of details) may be the most appropriate means of obtaining assurance regarding the accuracy of fixed asset additions. In obtaining assurance regarding the accuracy of depreciation expense, a combination of analytical procedures and tests of details (such as recalculation of individually significant amounts) may be appropriate. Like other auditing procedures, analytical procedures that are directed specifically at one or more audit objectives for a particular account balance or class of transactions may simultaneously address other accounts or objectives as well; the auditor should consider this when deciding how to obtain the necessary assurance for a particular account or objective.

Analytical Procedures Software

Software can be used to calculate absolute dollar and percentage changes, ratios, and trends, and to highlight significant changes, allowing the auditor to concentrate on evaluating the differences and obtaining explanations for them. This software is available on microcomputers, or by using utilities or software packages on minicomputers and mainframes. Increasingly, auditors use computers to compare entity data with industry data using public databases and microcomputer software. Software can perform virtually all of the analytical techniques discussed in this course.
Study Check 12 & 13
4.4.	Other Considerations in Using Analytical Procedures
The auditor may choose to use analytical procedures to help determine sample size, stratify a population, or assist in the design of other substantive tests. In determining the sample size necessary for auditing procedures related to inventory obsolescence, for example, the auditor may examine the change in inventory turnover rates for various components of inventory to decide which inventory items require more attention. Analytical procedures provide corroborative evidence about the accounting treatment of transactions and balances, and can also be good detectors of changes in accounting principles, though they will not alert the auditor to a misstatement if an inappropriate accounting principle remains unchanged. Analytical procedures may be particularly useful in helping the auditor to identify transactions that have not been recorded. Similarly, if the auditor performs substantive tests of details before year-end, analytical procedures can often provide evidence about the recording of transactions in the period between early testing and year-end.

The results of analytical procedures may possibly lead the auditor to extend testing. For example, the auditor might calculate the number of days' sales outstanding and observe that it had increased significantly, and management's explanation of that trend might not be adequate. In those circumstances, the auditor might decide to confirm more customer accounts than planned and to confirm them at the end of the year to ensure that fictitious receivables did not exist. The auditor also might expand tests for collectibility to ensure that the allowance for uncollectible accounts was adequate.

Scanning. Providing that the auditor has a thorough understanding of the account or schedule in question and the types of misstatements that could occur, scanning can be a particularly effective analytical procedure. For instance, in scanning an inventory listing, the auditor needs to know how the listing is categorized (that is, what items have been grouped together) and what constitutes a reasonable set of parameters for both quantity and price for each group. A larger than expected quantity of an inventory item might indicate an error in transferring information from the count sheets to the listing, or it might be indicative of slow-moving merchandise that needs to be considered in the valuation allowance. In addition, the auditor would investigate any price that was unexpectedly high or low. Similarly, an auditor scanning accounts receivable would be alert to negative amounts that might indicate the misapplication of cash or incomplete recording of sales, and also would watch for account balances with related parties. Scanning a listing of monthly charges to expense accounts can alert the auditor to abnormal items that may reflect errors. Scanning may also be used to test the remaining portion of an account balance after the auditor has examined several large items that constitute a significant portion of the balance.

Performance Reviews. Many performance reviews carried out by management are based on the use of analytical techniques to identify unusual transactions, balances, or relationships on a timely basis. Examples of data that may be subject to these reviews include operating budgets and results, sales analyses, inventory turnover and obsolescence reports, cash flow analyses, and forecasts. The auditor may identify such reviews when obtaining an understanding of the entity's internal control. Depending on the relevance and reliability of the reviews and of the underlying data, the information generated may be useful to the auditor in performing analytical procedures.

Analytical procedures may be performed using monetary amounts, physical quantities, ratios, or percentages. They may be applied to overall financial information of the entity, to financial information of components such as subsidiaries or divisions, and to individual elements of financial information. Some auditors have developed specialized software programs to extract appropriate entity data from computer files and perform standardized procedures. Other software packages require the auditor to input data to a computer, which processes the data and generates analytical reports.
Study Check 14
Unit Review
5.	Evaluation and Developing the Audit Program
5.1.	Evaluating Accounting Judgments
The auditor has a responsibility to evaluate the accounting judgments and estimates that management makes. The auditor's responsibility entails more than merely substantiating facts about specific transactions and other events and circumstances in order to achieve specific audit objectives for relevant accounts. The auditor is also responsible for evaluating how management has translated those facts into appropriate accounting presentations. Audit failures may result from the auditor's failure to evaluate the application of generally accepted accounting principles (GAAP), even when all of the relevant facts are available.

The possibility that financial statement misstatements may result from the intentional or unintentional misapplication of GAAP is a pervasive aspect of audit risk. Accordingly, it should be kept in mind at all times during the audit, not only when performing substantive tests directed at the valuation, rights and obligations, and presentation and disclosure objectives.

The auditor should evaluate the selection and application of accounting principles. The evaluation should include accounting judgments to address the risk that GAAP could be misapplied, intentionally or unintentionally, with respect to how transactions are accounted for and measured, and how they are presented and disclosed in the financial statements. The auditor's evaluation of the selection and application of GAAP requires consideration of the entity's environment, the industry involved, economic conditions, and numerous other intangible factors. Meeting that responsibility requires an extensive knowledge of accounting principles and of the ways in which they should be applied to produce financial statements that reflect, in all material respects, the substance of the entity's transactions and present a picture of the entity that is not misleading.
5.2.	Auditing Accounting Estimates
Achieving the valuation objective for many accounts requires the auditor to evaluate accounting estimates. Accounting estimates are financial statement approximations that are necessary because the measurement of an account is uncertain until the outcome of future events becomes known, or because relevant data concerning past events cannot be accumulated on a timely, cost-effective basis. Examples of the first type of accounting estimates include uncollectible receivables, obsolete inventory, useful lives of equipment, actuarial assumptions in employee benefit plans, and warranty claims. Examples of the second type of accounting estimates include allocating passenger ticket revenues to airlines other than those issuing the tickets, and telephone company revenues from long distance calls involving more than one company. SAS No. 57, Auditing Accounting Estimates, provides guidance to the auditor in auditing both types of estimates.

Management is responsible for making the necessary accounting estimates; the auditor is responsible for evaluating their reasonableness. Even when management's estimating process involves competent personnel using relevant and reliable data and the most likely assumptions about the factors that affect an accounting estimate, the subjectivity that enters into those estimates introduces the potential for bias. As a result, the auditor should evaluate accounting estimates with an attitude of professional skepticism. The auditor's objective in evaluating accounting estimates is to obtain sufficient competent evidence to provide reasonable assurance that all material accounting estimates have been developed, are reasonable, and are presented and disclosed in conformity with GAAP.

In evaluating the reasonableness of an estimate, the auditor should use one or a combination of three basic approaches.

1. Review and test the process management used to develop the estimate.
2. Independently develop an expectation of the estimate to corroborate the reasonableness of management's estimate.
3. Review events or transactions occurring after the date of the financial statements (but before the audit is completed) that provide an actual amount to compare with the estimate.

When following the first of these approaches, the auditor should:

•	Understand the process management established to develop each significant accounting estimate
•	Assess control risk related to management's process for developing the estimate
•	Assess the reliability of the underlying data that enters into the estimate
•	Determine that the calculations used to translate the underlying data and assumptions into the accounting estimate are accurate
•	Identify and evaluate the key factors and assumptions management used to formulate the estimate, concentrating on those key factors and assumptions that are:
—Material to the estimate
—Sensitive to variations
—Deviations from historical patterns
—Subjective, and therefore susceptible to misstatement and bias

Procedures helpful to the last suggestion, identifying and evaluating the key factors and assumptions, are unique to auditing accounting estimates. They may involve some or all of the following steps:

•	Identifying the sources of information that management used to formulate the assumptions and considering, based on information obtained from other audit tests, whether the information is relevant, reliable, and sufficient for the purpose
•	Considering whether there are additional key factors or alternative assumptions
•	Evaluating whether the assumptions are consistent with one another, with the supporting data, and with relevant historical data
•	Analyzing historical data used in developing the assumptions to assess whether it is comparable and consistent with data of the period under audit, and determining whether it is sufficiently reliable
•	Considering whether changes in the business or industry or in other facts or circumstances may cause factors different from those considered in the past to become significant to the accounting estimate
•	Reviewing available documentation of the assumptions used in developing the accounting estimate and inquiring about any other relevant plans, goals, and objectives of the entity; and considering their relationship to the assumptions
•	Consider using the work of a specialist [SAS No. 73, Using the Work of a Specialist (AU Section 336)]
Study Check 15
5.3.	Evaluating the Results of Substantive Tests
When misstatements are found as a result of substantive tests, the auditor should ascertain the reason for them and consider the implications with respect to the entity's internal control. Misstatements may lead the auditor to reconsider the understanding of internal control and the control risk assessment. For example, control risk relating to accounts receivable may have been assessed at low with respect to the recording of sales and customer receipts; however, positive confirmation requests indicate numerous unexpected misstatements. Upon further review, the auditor discovers that an unauthorized program change occurred during the year—a control deficiency not previously identified in assessing control risk. The auditor should reconsider the understanding of computer controls and the assessment of control risk, and amend the relevant documentation of the understanding of computer controls and control risk assessment.

If the nature or frequency of misstatements indicates the possibility of significant misstatement in the account balance in which they were found or in related account balances, the auditor should consider the implications for the audit strategy and the audit opinion and take appropriate action. Possible auditor actions include:

•	Asking management to adjust for all or some of the known and projected misstatements
•	Asking management to perform additional work to determine whether there are additional misstatements in the account balance
•	Extending the planned auditing procedures to obtain additional evidence about misstatements or to demonstrate that the account balance is not materially misstated; in determining whether additional evidence is necessary, the auditor should consider the effect of evidence obtained from substantive tests (including analytical procedures) of other accounts and audit objectives, as well as evidence from tests directed specifically at the account and audit objective under consideration
•	Concluding that the financial statements are materially misstated and modifying the audit report accordingly

Auditors often maintain a summary of misstatements of various types (known misstatements, amounts projected from sampling applications, and unreasonable accounting estimates) found as a result of their auditing procedures. At the completion of the audit, the summary is evaluated to determine whether adjustments to account balances are necessary before the auditor can conclude that the financial statements are presented fairly, in all material respects, in conformity with generally accepted accounting principles.
5.4.	Developing the Audit Program
Auditing procedures are compiled into a document referred to as an audit program. An audit program is a list of steps to be performed in the course of an audit. It typically specifies the nature, timing, and extent of the audit work, aids in scheduling and assigning the work, guards against possible omissions and duplications, and provides part of the documentation of the work done. An audit program is necessary for adequate planning and supervision of an engagement under the first standard of fieldwork, and is required by SAS No. 22, Planning and Supervision (AU Section 311). The auditor should revise the audit program as new information is obtained during the audit.

The audit program should be organized in a way that provides for the efficient performance of the procedures listed. More specifically, the program should be organized so that when an auditor examines a particular document as many of the planned auditing procedures as possible are performed. For instance, assume that one auditing procedure calls for examining vendor invoices for initials indicating that the invoice was reviewed for mathematical accuracy and matched to a purchase order and receiving document, and that another auditing procedure calls for examining vendor invoices for evidence that they were authorized for payment. Combining these auditing procedures into one audit program step will enhance audit efficiency.

Auditors differ over the degree of detail that an audit program should include. Some auditors believe that an audit program should be as general as possible and that someone wanting to know what detailed audit steps were performed can find that information by looking at the working papers that report the results of the audit tests. Such an audit program might, for example, include the step, "Perform tests of controls applied to shipments." Other auditors believe that the audit program should be as detailed and specific as possible. The advantage of this is that two people reading the audit program would perform exactly the same audit tests on the same number of transactions or balances. An audit program that reflected this attitude might contain the step, "Examine 75 shipping documents for signature of individual authorized to release merchandise from warehouse." If this approach is used, care should be taken not to eliminate judgment from the audit process and make that process somewhat mechanical. Either approach may be consistent with an efficient and effective audit as long as the work is planned and supervised appropriately for the particular type of audit program, and the education and training of the auditor performing the procedures are adequate to enable the individual to make the necessary judgments.
Study Check 17
Unit Review