SUBSTANTIVE PROCEDURES ON FINANCIAL STATEMENT
- Non-Current Assets
- Sales and Receivables
- Purchases and Payables
- Cash and Bank
- Capital, Reserves, Liabilities.
- Contingencies and Provision
- Analytical Procedures
By the end of this chapter, students should be able to:
Carry out detailed audit tests on elements of financial statements.
Collection and evaluation of evidence obtained.
This chapter covers detailed audit tests carried out to verify financial statements assertions relevant to each element of the financial statements. They involve carrying out substantive tests on their resulting records and assets and obligations on their account balances, classes of transactions and disclosures.
- Non-Current Assets
- Year End Substantive Tests on Non-Current Assets
The auditor should obtain sufficient appropriate evidence to support financial statements assertions relevant to non-current assets (ie, existence, valuation, completeness and ownership) in addition to the control tests outlined above.
The auditor should;
- Obtain or compile a list of assets to support the balances shown in the financial statements and verify them in the non-current assets register
- Verify the existence of each asset through physical inspection, matching the detailed descriptions in the register with actual assets
- Check through all records on each asset and ensure that there is no indication that the assets have not been lost, disposed of or stolen
- Seek confirmation from responsible management about the existence of the assets if not around the premises for some reasons.
Ownership (rights and obligation) The auditor should;
- Check whether assets are owned by the client by inspecting ownership documents (ie, registration books for motor vehicles, title deeds for land and buildings etc) and ensure they are in the client’s name.
- Verify through purchase documents (purchase invoices, quotations etc) and ensure they were ordered and paid for by the company.
- Observe use of the assets by the client without any encumbrances or attached conditions from any third party.
- Confirm with responsible management of the ownership of any asset which the auditor doubts or other proof is not readily available.
- Check all assts held under lease agreement and conditions attached to such leases in the lease agreements
- Assess whether each asset is adequately ensured against risks to which it is exposed, accidents, theft and so on.
- Check whether any asset is held subject to loan security against providers of loan capital.
- For self-constructed assets verify through costing information in contracts accounts.
Completeness, Presentation and Disclosure The auditor should;
- Obtain or compile a list of all the non-current assets held by the client entity and trace each asset in the non-current asset register.
- Check whether appropriate details about each asset are contained in the register such as;
Dates of acquisition
Names and details of suppliers
Description of each asset (ie, year of make, model, serial numbers, part number, colour etc)
Current location, use and condition
Asset life history in terms of major repairs or replacement of parts
Asset depreciation policies and rates
Asset insurance policies and annual premiums paid
- Verify information from the register with other information for example, with the asset ledger.
The auditor should;
- Trace the original cost of each asset through the asset register and cross-check with purchase documents and ensure they were appropriately classified as capital expenditure.
- Trace any subsequent capital additions and ensure they meet the requirement to be classified as such (ie, that the costs enhance the capacity or capability of the assets, not maintenance and other running costs)
- Check any subsequent revaluation of the assets for reasonableness, especially noting the competence of valuers, assumptions and methods used to arrive at the values.
- Check whether annual reviews are carried out at the balance sheet date and any impairments are provided for.
- Check reasonableness of depreciation policies, adequacy and accuracy of the calculations of annual depreciation.
- Assess whether each asset is adequately ensured against risks to which it is exposed.
These include investments in: joint ventures, associates, subsidiaries and bond stocks The following are the typical assertions to be considered:
Ownership and Existence:
- These should be verified by inspection of details about each investment through certificate of title from stock brokers
- Obtain third party confirmation from brokers
- Verify income received in respect of these assets through dividends, interests etc.
- Check through board minutes or statutory books
- Review valuation from the market through relevant media for those listed on the stock exchange.
- Perform independent valuation techniques to assess the reasonableness of the reported values, for any over or under valuations
- Check additions and disposals within the period and reconcile opening and closing balances.
- Review revaluations and impairment provisions for the period.
- For investments where there is control, check the determination and annual reviews of goodwill on them
- Obtain appropriate management representations over investments.
- Inventory (Stocks)
Auditors need to pay particular attention to inventory figure in the financial statements when verifying assertions relevant to it for the following reasons;
- In some organizations inventory may be composed of a large number of different items.
- There exists different valuation methods under the Companies Act and the International Accounting Standard 2 (IAS 2) on inventory.
- It is usually composed of small items or valuable items susceptible to loss, pilferage, damage and deterioration.
- Misstatements in valuation (or different valuation methods used) would have a direct impact on the gross profit and net profit in the income statement.
- Valuation of work in progress may be difficult since it depends on completion levels.
- Accounting for Inventory:
Principles of accounting for inventory are contained in the Companies Act and the IAS 2 Inventories.
Valuation of inventory movements can be done on the following bases:
- FIFO: this is a recommended method by IAS2 and the Companies Act (1984) for published financial statements in Malawi
- LIFO and WAC – allowed alternatives in certain circumstances.
- Other methods such as standard cost and replacement cost etc, can be used for management accounts only.
Inventory should be presented in financial statements at cost value (as above) or at its net realizable value if lower.
Cost is the expenditure that has been incurred in normal course of business in bringing the item to its present location and condition.
Net realizable value (NRV) is the actual or estimated selling price of the item less any further costs to sale (ie completion, marketing and distribution costs).
- Auditors Responsibility
The auditor should obtain sufficient appropriate evidence to ensure completeness in the inventory records, existence, measurement and valuation of inventories shown in financial statements.
The auditor should therefore carry out the following to obtain the evidence;
- Ascertain, test and evaluate control exercised over inventory
- Carry out substantive tests over year-end inventory balances shown in the financial statements for any possible misstatements. This largely achieved through attendance of year-end inventory count (Stock take), conducted by management to determine the inventory figures to be included in the financial statements.
3.4 Inventory Count (Stock Taking)
Inventory count is the responsibility of management. It is carried out to achieve the following objectives;
- As a control and accuracy check over inventory records and actual inventory held (regular and continuous stock takes).
- Carried out at year-end or around that period to establish or confirm inventory figures to be included in the financial statements as closing stocks for the period.
The auditor’s responsibility is to attend one of the counts, especially the year end count to verify existence, quantities and values of inventories included in the financial statements by carrying out the following procedures;
Planning the Attendance Before the Count
- Review previous periods’ arrangements (if it is a continuing audit) and discuss with management any changes in arrangements to the count. Familiarization with the nature, volume and location of the inventories Check specific methods of counting and measuring the inventory.
- Consider the allocation of audit staff and ensure appropriate attention is paid to items with high values.
- Consider any items held by third parties and make arrangements to verify them, while also considering whether the client entity holds any items that belong to third parties.
- Consider whether the nature of some items of inventory would require an expert’s assistance to verify or value.
- Review count instructions for organization and reasonableness and check the count procedures and recording and discuss with management any inadequacies in terms of:
o Counting is to be carried out by pairs o Adequacy of supervision arrangements o Restriction of movements of inventory during the count o Systematic counting, checking and recording in serial numbered sheets
Procedures During the Count
- Check whether the client’s staff are following instructions as laid down, during the count.
- Make test-counts or request recounts where in doubt to confirm the results.
- Check procedures over identification of damaged or deteriorated items.
- Ensure restriction of movements, or that proper account is taken of any inventory movements during the count.
- Make conclusions as to whether the count has been properly carried out and is a sufficient and reliable basis for determining existence, quantities and values of inventory.
- Consider the results of the count in light of evidence obtained from other procedures.
Procedures After the Count
- Check that all count records have been included and consolidated into the final inventory sheet.
- Ensure that continuous inventory records have been adjusted to the amounts physically counted and that discrepancies have been investigated.
- Confirm that appropriate cut-off procedures were applied to ensure items included are only those that belong to the accounting period (ie, use of serial number and dates for purchases and goods, and sales and goods outwards)
- Check whether proper account has been taken for any inventory held by third parties, or the client holding of any items belonging to third parties.
- Confirm the client’s final valuation of inventory has been calculated correctly (at the lower of cost and NRV, especially taking into consideration damages, deteriorate and obsolete items identified during the count.
3.5 Sales and Receivables (Debtors)
The auditor should obtain sufficient appropriate evidence to support financial statements assertions relevant to sales and receivables such as, validity, accuracy and completeness on year-end figures, in addition to the control tests carried out above.
- Year-End Substantive Tests on Receivables (Debtors) Balances
Auditors should obtain sufficient appropriate evidence to ensure validity, accuracy and completeness of the sales records and year end balances and existence and valuation of debtors. There is particularly a risk that they may be overstated. In addition to control tests carried out above, the auditor should carry out the following tests;
- Compile or obtain a list of debtors outstanding at the year end to support the total debtors figure in the balance sheet.
- Confirm the totals with control accounts balances
- Follow up with management with any unusual items, for example; contra entries against the purchases ledger, irregular accounts etc.
- Carry out a debtors age analysis and enquire into any long outstanding balances.
- Check bad debts written off during the year for reasons, correspondence and authorization for write-off of debts considered irrecoverable.
- Check adequacy of provisions for doubtful debts in light of subsequent bad debts for previous estimates or provisions.
- Review and test the year end cut-off procedures for the sales.
- Supplement the evidence obtained from internal sources with debtors’ circularization.
4.1 Receivables (Debtors) Circularisation
A debtors’ circularization is a direct confirmation of balances from debtors themselves. It is an important source of evidence because it provides a direct external evidence about debtors existence and ownership. It also confirms the effectiveness of internal controls but may also reveal evidence of items in dispute.
A circularization may be positive, where the auditor requires the debtors to respond whether they agree with the balances or not, or negative where the auditors requires debtors to respond only where they don’t agree with the balance indicated. When selecting which debtors to circularize, particular attention should be paid to the following; (why?)
- Long outstanding accounts
- Accounts written off during the period under review Accounts with credit balances, or zero balances
- Accounts settled by round sum payments.
- Accounts with significant closing balances
- Accounts with large throughput irrespective of their year-end amounts outstanding.
Although it should bear the client’s letter head, a circularization letter should be sent direct to the debtors and their response should be addressed direct to the auditors. The auditors should then review the responses and enquire into any disputed balances to establish the cause of the differences (it could be items in transit, or errors or even fraud). Non response should be followed up especially positive circularization (by a second letter or telephones etc), or else they may indicate non-existence.
The auditor should also carry out analytical procedures relevant to credit sales, debtors and irrecoverable debts to assess reasonableness and discover any unexpected relationships and trends, for example; calculate debtors/sales ratios, bad debts/debtors ratios and debtors days and compare them with previous periods ratios or other entities’ ratios in the same industry.
- Substantive Tests on Year-End Payables (Creditors) Balances
Auditors should obtain sufficient appropriate evidence on purchases and payables balances to ensure; the existence of liabilities shown in the balance sheet
- Rights and obligations over these liabilities
- Correctness of the amounts shown and completeness in the information, appropriateness of descriptions and disclosures.
This area is particularly susceptible to understatement in the financial statements. The auditor should therefore carry out the following tests;
- Obtain or compile a list of payables balances to support the total balance shown in the balance sheet.
- Reconcile the ledger totals with control account balances.
- Carry out a balance age analysis and enquire from management into any long outstanding balances.
- For selected balances, check the appropriateness of debit and credit entries and balances.
- Recast and rebalance the purchases ledger, especially accounts with large throughput.
- Obtain direct confirmation from selected balances through a circularization and enquire into any disputed balances.
- Review the year end cut-off procedures for appropriateness to ensure that all items included really relate to the accounting period under review and that relevant items have not been excluded.
- Carry out appropriate analytical procedures around purchases and payables such as calculating, creditors to purchases ratios and creditors days and comparing them with previous periods results or other entities in the same industry.
- Cash and Bank
The auditor needs to pay particular attention to cash/bank because of the following reasons:
- It is the centre of all business operations with high throughput of entries.
- Because of their liquidity, they represent the most vulnerable of the entity’s assets irrespective of their relative materiality in the year-end figures in the financial statements
by carrying out the following tests;
- from bank reconciliations.
Normally entities should strive to keep cash transactions to the minimum, especially on the payments side. Any cash received should be banked intact and promptly as seen above. Where the entity maintains some petty cash, because of the inevitability to make small payment in cash, then an imprest system should be used.
Audit tests should be carried out to obtain evidence to support the validity of cash transactions, the accuracy of the record and the existence of the cash balances. The auditor should therefore carry out the following procedures;
- Obtain the petty cashbook and the validity of entries by tracing each entry to the original documents
- Check casting and balances for accuracy.
- Verify the existence of the cash by attending a cash count and ensure all discrepancies have been resolved.
- Share Capital, Reserves and Long Term Liabilities
The auditor should carry out his work with the objective to ensure that;
- Share capital has been properly classified and disclosed in the financial statements.
- Movements on reserves, such as capitalization through bonus share issue, have been properly authorized and that statutory reserves are only used for permitted purposes.
- Statutory records have properly maintained.
Types of Reserves;
- Share premium reserves
- Revaluation reserves
- Capital reserves
- Replacement reserves
- Debenture redemption reserves
- Profit reserves
The auditor should carry out the procedures;
- Check authorized capital limit to the memorandum and articles of association.
- Check changes to issued capital in the year, through fresh, rights or bonus issues, and confirm with its authorization to the board minutes.
- Trace all transactions involving cash to the cashbook and bank statement.
- Obtain confirmation that all statutory and appropriate returns have been made to the registrar of companies and inspect all statutory books for appropriate disclosures
- Ensure that all related parties, including directors’ interests and transactions with the company, have been properly disclosed in accordance with IAS 24 on related party disclosures.
- Ensure capital and reserves have been appropriately disclosed and presented in accordance with IAS 39 on financial instruments
The auditor should also carry out audit procedure on long term liabilities to verify completeness, disclosure and correctness of measurement of the amounts of liabilities. He should carry out the following procedures;
- Obtain or compile a schedule of loans to support the totals in the financial statements.
- Compare opening balances to the previous periods closing balances and trace changes within the period.
- Trace them to the ledger and check clerical accuracy of the records.
- Check names and other details of lenders.
- Trace additions and repayments and compare with borrowing limits imposed by the articles of association and other agreements.
- Verify interest rates in the loan agreements and interest charges and payments for the period in the cashbook.
- Provisions and Contingences
A provision is a liability of uncertain timing or amount.
A liability is a present obligation arising from past events.
An obligation may be;
Legal; if there exists a contract or if required by the law
Constructive; if there exists an established pattern of past practices, policies etc
A Contingent Liability (IAS 37),
Is a possible obligation arising from past events whose existence would be confirmed only by occurrence or non-occurrence of an uncertain future event not wholly within the entity’s control.
A Contingent Asset
Is a possible asset arising from past events whose existence would be confirmed only by occurrence or non-occurrence of an uncertain future event not wholly within the entity’s control.
A contingent asset should not be recognized in the financial statements. However if it becomes probable that outflows of future economic benefits will occur because of previous contingent liabilities, a provision should be made.
Examples of situations from which provisions may arise include;
- Share options
- Discounted bills of exchange etc
When considering the audit of contingent liabilities and provisions, auditors should bear in mind that most such matter’s knowledge is confined to management and there is possibility of non-disclosure of such matters especially if they have unfavorable effect on the financial statements or the entity. Auditors should carry out the following procedures; Make appropriate enquiries and obtain confirmations from management.
- Review board minutes.
- Examine legal expenses account.
- Obtain any other information regarding the entity’s business that may lead to contingencies or provisions including obtaining experts’ opinion such as legal opinions on lawsuits.
- Check whether appropriate disclosures and descriptions and recognition have been carried out by management.
- For directly indentified litigation or where the auditor reasonably believes they exist, he should seek direct confirmation from lawyers
- Obtain detailed list of provisions included in the financial statements.
- Assess for each whether there is a present obligation as a result of past events and review correspondences to that effect and discuss with management.
Consider the adequacy of disclosures of provisions, contingent assets and liabilities and ensure contingent assets have not been recognized.
- Analytical Procedures (ISA 520)
Analytical procedures involve analysis of relationships between items of financial data, or financial and non-financial data, derived from the same period with comparative financial information derived from different periods or organizations in the same industry. The purpose of analytical procedures or reviews is to identify consistencies and predicted patterns or significant fluctuations and unexpected relationships and trends.
Comparisons can be made with:
- Similar prior periods analyses
- Other businesses in the same industry, subject to the availability of information.
- Budgeted results
- Auditor’s own expected results
Analytical procedures are helpful and can be carried out at different stages of the audit process as follows;
- Audit Planning
Auditors should apply analytical procedures when planning their audits (for example, through a preliminary ratio analysis) to assist them to understand the client’s business, identify areas of potential risk, and planning the nature, timing and extent of other audit procedures to be carried out (Analytical procedures use during audit planning has extensively been covered in earlier chapters).
- Analytical Procedures as Substantive Tests
Auditors should assess the effectiveness and use of analytical procedures with other substantive tests to reduce detection risk for specific statements or elements’ assertions, such as debtors, creditors and stocks.
Analytical procedures in this context are not tests of detail as such. They can be considered a more global approach to substantive testing. Instead of selecting a sample of transactions or balances that make up the overall figures in the accounts, the overall figure itself can be analysed for accuracy using various techniques. Analytical procedures involve the analysis of relationships between:
- Balances within the accounts
- Balances in the accounts with other internal data
- Balances in the accounts with other external data
Specific examples could include:
- Monitoring the trend in key ratios over time
- Comparing key ratios with similar companies or with industry averages
- Comparing balances with other known information
The approach to analytical procedures is:
- Identify relationships between data, ensuring they are fully understood
- Develop expectation of balance in the accounts
- Compare expectation to actual balance
- Seek explanations for material differences
Factors that will affect the use of analytical procedures: Strength of relationships
- Reliability of the data being used in the analysis
- Depth of knowledge auditor has of client business and industry in general, use of analytical procedures can be particularly difficult for new clients
In general, a company with many similar divisions (e.g. a chain of shops) provides great scope for comparison of data. Comparison of data is one of the general types of internal control procedure. In other words, many companies will be doing their own regular analytical procedures themselves. It may be possible for the external auditor to rely on
the analysis carried out by the company, but this will depend on the reliability of those who did the work.
For example, we could get evidence as to the accuracy of the current year payroll expense in the statement of comprehensive income by:
- Comparing the figure with last year’s figure, noting: Starters and leavers, any pay rises/tax changes during the year
- Comparing payroll with other related figures in the FS. This will depend on the specific company, but could include:
- Turnover (especially if staff time is charged to clients)
- Profit (especially if staff get profit-related bonuses)
- Staff entertainment expenses
- At final Stage
When completing the audit, auditors should use analytical procedures in forming an overall conclusion as to whether financial statements as a whole are consistent with the auditor’s expectation and knowledge of business.
Auditors should carry out further investigations when significant fluctuations and unexpected relationships are identified that are inconsistent with other relevant information or that deviates from predicted patterns, to obtain adequate explanations and appropriate corroborative evidence. Significant areas that need consideration include; Liquidity and working capital ratios.
- Long term gearing ratios
- Profitability ratios and
- Efficiency ratios.
Such analysis may also help the auditor understand the client’s business and its performance more and be able to assess its ability to continue as a going concern and compare its consistency with the basis on which financial statements have been prepared, discuss with management or qualify the audit report if appropriate.
End of Chapter Questions
You are the auditor of Takondwa Traders Limited whose year-end receivables balance, you have verified in the ledgers, is K4,319,400. You have also requested for and provided with the debt age analysis given below. The chief accountant has informed you that receivable days have increased from 40 to 55. As a source of additional evidence you intend to obtain a direct confirmation from some of the balances through a circularization.
Number of range of debt current 1 to 2 more than total
Accounts (K) (K) months (K) 2 months (K) (K)
3 negative (58,250) (58,250)
150 1 to 50,000 350,000 495,200 645,000 1,490,200 8 50,001 to 100,000 578,450 750,500 387,000 1,715,950
2 100,001 or more 875,000 – 296,800 1,171,800
163 1,745,200 1,245,200 1,328,800 4,319,400
- What would you aim to discover by carrying out a circularization of the receivables’ balances? 4 Marks
- Explain the advantages of using a positive circularization in one instance and a negative circularization in another. Can both procedures be used in the same audit?
- What action should you take if Takondwa Traders Limited management refuses to agree to the debtors’ circularization being undertaken? 4 Marks
- Circularization has been undertaken, and one of the companies circularized has replied that it disputes the amount claimed by Takondwa Traders. Briefly describe the possible causes of such disputes and the action you would take as auditor. 4 Marks
- Your audit firm intends to obtain confirmation from at least 50 accounts. Which ones, from the above, should you particularly not ignore from the selection and why?
(TOTAL: 20 Marks)
You are a member of the audit team that is currently conducting a final audit at one of the Bela Group subsidiaries.
State how you would verify the following items appearing in the annual financial statements of the subsidiary:
- Bank overdraft 3 Marks
- Trade Debtors 6 Marks
- Land and buildings 6 Marks
- Trade creditors 3 Marks
- Current account with head office 2 Marks
Total 20 Marks