CHAPTER 13
Substantive procedures —
key financial statement
figures
Introduction
Examinationcontext
Topic List
1 Non-current assets
2 Inventory
3 Receivables
4 Bank
5 Payables
6 Long-term liabilities
7 Income statement items
Summaryand Self-test
Technicalreference
Answers to Interactive questions
Answers to Self-test
211
ntroduet{on—
Learning objectives Tickoff
• Understand the natureof testson balancescarriedout by assuranceproviders and the
objectives of those tests
Identify suitable tests in a given businessscenario
• Understandwhen a mattershould be referredto a senior member of staff
Specific syllabus referencesfor this chapter are: 3f, i.
Syllabus links
The resultsof the testsoutlined herewill be the basisfor the drawing conclusions part of your Audit and
Assurance paper.
Examination context
Questions about assuranceevidence could be set in the context of any balances outlined in this chapter.
In the assessment,candidates may be requiredto:
Select appropriateaudit proceduresfor a given financialstatement assertion
Identify the featuresof externalconfirmation requests
Identify why the resultsof a physical inventorycount may differfrom inventory records
Identify the procedureswhich should be undertakento confirm the existence of cash at bank
Evaluatethe resultsof audit work and identify issuesthat should be referredto a senior colleague
212 Assurance
1 Non-current assets
Sectionoverview
Key areaswhen testingtangible non-currentassetsare:
Confirmation of ownership (rights and obligations)
Inspection of non-current assets(existence and valuation)
Valuation, preferablyby third parties(valuation)
Adequacy of depreciation rates (valuation)
• Key areaswhen testing intangible non-currentassetsare:
Confirmation that 'assets'exist
Confirmation of appropriate valuation
Key areas when testing investments are:
Confirmation of existence
Confirmation of ownership
1.1 Tangible non-current assets
You should be aware of the majorclassesof tangible non-currentassetsfrom your Accounting studies.
Examples of tangible non-current assetsinclude land, buildings, plant, vehicles, fittings and equipment.
The major risks of the tangible non-current asset balances in the financial statements being misstated are
due to:
The company not actually owning the assets(rights and obligations assertion)
The assets not actually existing or having been sold by the company (existence assertion)
Omission of assetsowned by the company (completenessassertion)
The assets being overvalued, either by inflating cost or valuation, or by undercharging depreciation
(valuation assertion)
• The assetsbeing undervalued,by not including an appropriaterevaluationin a policy of
revaluation or by overcharging depreciation (valuation assertion)
The assets being incorrectly presented in the financial statements(presentation and disclosure
assertion)
The objective of assurance tests in respect of non-current assetsis thereforeto prove that these
assertions about the assets are correct.There are severalsourcesof informationabout non-current assets
that can be used (you should consider the strengths and weaknessesof all the sourcesof evidence listed
in this chapter according to the criteriawe setout in Chapter 11):
• The non-current asset register (which many companies maintain as a control over the assets they
own)
Purchase invoices for assets purchased within the year
Sales invoices for assets sold within the year
Registration documents or other documents of title such as title deeds for property
• Valuations carried out by employees or third partyvaluers
Leases or hire purchase documentation in respectof assets
Physical inspection of the assetsthemselvesby the auditor
Depreciation records or calculations (these are often kept with the asset register)
Substantive procedures—key financial statement figures 213
Worked example: Non-current assetassurance engagement
Peteris carrying out a non-currentassetassuranceengagement at ManufacturingCompany Limited
(MCL). MCL owns the propertyfromwhich it operates.It hasa lot of fixed plant' which it replacedthree
years ago, and owns severalindustrialvehiclesfor moving inventorybetween locations at its premises.It
also owns a number of cars, which its staffhave as company cars, and a great deal OfOfficefurniture,
fittings and computers in the office complex attached to the factory.
Peteris concerned with concluding that the non-currentassetsdeclared in the financial statementsare
complete, exist, are owned by the company and arevalued appropriately.
Completeness
Peter will:
Obtain a schedule of non-currentassetsfrom the client
Agree the figures per the scheduleto thefinancialstatementsand accounting records (nominal
ledger)
Compare the schedule to the asset register to ensure that the schedule reflects all the assets owned
by the company
Select a number of assets physically present on site and ensure that they are contained in the asset
register
Confirm the additionson the scheduleare correct
Existence
Peter will:
Select a sample of assets contained in the asset register and verify that they are physically present
on site
Rights and obligations
Peter will:
Select a sample of assetsin the assetregisterand vouch them to the registrationdocuments
available for those assets (vehicles —registration documents (although these indicate who is the
'registeredkeeper',who is not necessarilythe owner), building —title deeds, plant and fixtures—
purchase invoice, ensuring that it is not a lease)
Review sales invoices for sold assetsto ensure that ownership has been transferred
Valuation
Peter will:
• Confirm the cost or valuation of a sample of assets to purchase invoices or valuation certificates
• Confirm the brought forward depreciation levels of those assets (if relevant) to prior year audit files
or by reviewing the brought forward asset register files
Confirm the annual depreciationin respectof thoseassetsis appropriate (by referenceto theaccounting policy on depreciationpublishedin thefinancialstatements),and correctly calculated(by recalculationor by using analyticalprocedures)
Reviewto ensurethat depreciationhas been correctlycalculated on disposed assets, andrecalculate profit or loss on sale of those assets
Presentation and disclosure
Peter will review the financial statements to ensure that the disclosure requirements relating tonon-current assets have been met
214 Assurance
Other matters
Peteris likely to focus assettesting on assetadditions, as thesewill comprise a large proportion of
the cost of non-current assetsas they will have been depreciated the least
Peterwill use sampling on some classesof assetsand not others. For example, in this instance,
property is likely to be a materialbalance and thereforewill be vouched 100%. Other classesof
assetsare likely to be sampled as the overalltotal contains a large number of assets
Worked example: Self-constructedassets
Katieisworking on the audit of Quickshop plc, a largesupermarketchain. She has been allocatedthe
audit of non-current assets.One aspect of this audit is the fact that the company has built four new
superstoresduring the year, which have been capitalisedinto non-current assets.The key objectives she
is working on are that all the relevantcosts have been capitalised(completeness)and that the self-built
storesare valued correctly at cost (valuation).
Completeness
Katie will:
• Obtain architect's certificates for the stores, certifying that the work is complete
• Obtain a schedule of all the costs capitalised into the stores; this is also likely to have been verified
by the contractor, giving comfort that the costs are complete
Valuation
Katie will:
Vouch a sample of costs to appropriate sources of evidence, for example, labour costs to payroll
records or contractor bills, materials costs to purchase invoices or contractor bills, finance costs to
statements from lenders (for example, bank statements)
In respect of finance costs, Katie will review bank statements to ensure that all relevant finance
costs have been included
Interactive question 1: Non-current assets
Which three of the following might an auditorvouch when testing the rights and obligations of a
company in respectof a vehicle?
A purchase invoice
A registrationdocument
A hire-purchase agreement
An asset register
See Answer at the end of this chapter.
Substantiveprocedures—key financialstatementfigures 215
1.2 Intangible non-currentassets
Examples of intangible assetsinclude licences,development costs and purchased brands.
The major risksof misstatementof the intangible non-currentassetbalances in the financial Statements
are due to:
• Expenses being capitalised as non-currentassetsinappropriately(existence assertion)
Intangible assets being carried at the wrong cost or valuation due to inflating the cost or valuation
(valuation assertion)
Intangible assetsbeing carriedat the wrong cost or valuationdue to charging inappropriate
amortisation, wrongly amortising or not amortising (valuationassertion)
Intangible assetsbeing carriedat the wrong cost or valuationdue to impairment reviews not being
carried out appropriately (valuationassertion)
The objective of tests in respectof intangible non-currentassetsis thereforeto prove that these
assertionsabout the assetsarecorrect.The following sourcesof informationcan be used:
• Accounting standards/auditor'sknowledge of accounting standardsfor what constitutes an
intangibleasset
Purchase invoices or documentation (particularlyfor, say, purchased intangibles)
• Client calculations and schedules
Specialistvaluations
• Auditor understanding of the entity for signs of impairmentfactors
2 Inventory
Section overview
• Key areaswhen testing inventory are:
Attending an inventory count (existence)
Valuation at the lowerof cost and net realisablevalue (valuation)
In some cases, confirmation of ownership (rights and obligations)
The major risksof misstatementof the inventory balance in the financial statements are due to:
Inventory that does not exist being included in the financial statements(existence)
• Not all inventory that exists being included in the financial statements(completeness)
Inventory being included in the financial statementsat full value when it is obsolete or damaged
(valuation)
Inventory being included in the financial statementsat the wrong value, whether due to
miscalculation of cost or the fact that cost has been used although net realisablevalue is lower than
cost (valuation)
Inventory that actually belongs to third partiesbeing included in the financial statements (rights
and obligations)
Inventory which has actually been sold is included in the financial statements (cut-off)
216
The objective of assurance tests in respect of inventory is therefore to prove that these assertions about
the assets are correct. The following sources of information can be used:
The company's controls over inventory counting
The auditors'attendanceat the annual inventorycount
Confirmationswith third partiesholding inventoryor having inventorystoredfor them by the
company
Purchase invoices for inventory
• Work-in-progress recordsfor inventory
Post-year-end sales invoices for inventory
Post-year-end price lists for inventory
Post-year-end sales orders
Inventory may lend itself to analytical reviewas there is a relationship between inventory, revenue and
purchases.
2.1 Inventory count
Attendance at an inventory count can be very important. In order to confirm the amount of inventory in
existence, rather than undertake a count itself, assurance providers usually rely on the controls that a
company has in operation over its inventory or its annual inventory count.
It is important that the assuranceprovider is satisfiedthat controls are such that it can be concluded that
the count, or the overall inventorycontrols, are capable of ensuring the correct amount of inventory is
reflected in the financial statements.
In terms of inventory counts, the assuranceproviderwill be looking for the following sorts of controls.
Review of inventory count instructlons
Organisation
of count
Counting
Recording
Supervision by senior staff, including senior staff not normally involved with
inventory
Tidying and marking inventoryto helpcounting
Restriction and control of the production processand inventory movements during
the count
Identification of damaged, obsolete, slow-moving, third party and returnable
inventory
Systematic counting to ensureall inventory is counted
Teamsof two counters, with one counting and the otherchecking, or two
independent counts
Serial numbering, control and return ofall inventorysheets
Inventorysheets being completed in ink and signed
Information to be recordedon thecount records (locationand identity,count
units, quantity counted, conditions of items, stage reached in production process)
Recordingof quantity, conditions andstage of production of work-in-progress
Recording of last numbers of goods inwards and outwards records and of internal
transfer records
Reconciliationwithinventory records and investigation and correctionof any
differences
Some companies have better day-to-day controlsover inventoriesthan others and many have complex
systems of perpetual counting rendering an annual year-end count unnecessary. In order to rely on such
Substantive procedures —key financial statement figures 217
a system of perpetual counting, the assuranceprovider needs to confirm that the controls over this
system are strong.
If perpetual inventory counting is used, assurance providerswill check that management:
(a) Ensures that all inventory lines are counted at least once a year.
(b) Maintains adequate inventory records that are kept up-to-date. Assurance providers may
compare sales and purchase transactionswith inventory movements, and carry out other testson
the inventory records, for example checking casts and classification of inventory.
(c) Has satisfactory procedures for inventory counts and test-counting. Assuranceprovidersshould
confirm the inventory count arrangements and instructionsare as rigorous as those for a year-end
inventory count by reviewing instructionsand observing counts. Assurance providers will be
particularly concerned with cut-off; that thereare no inventory movements whilst the count is
taking place, and inventory recordsare updated up until the time of the inventory counts.
(d) Investigates and corrects all material differences. Reasonsfor differencesshould be recordedand
any necessary correctiveaction taken. All correctionsto inventory movements should be
authorised by a managerwho has not been involved in the detailed work; these procedures are
necessaryto guard against the possibilitythat inventoryrecordsmay be adjusted to conceal
shortages.
Audit plan: Perpetual inventory count
Attend one of the inventory counts (to observeand confirm that instructions are being adhered to)
Follow up the inventory counts attended to comparequantitiescountedby the assuranceproviders
with the inventory records, obtaining and verifying explanations for any differences, and checking that
the client has reconciled count recordswith book records
Review the year's counts to confirm the extent of counting, the treatmentof discrepancies and the
overall accuracy of records (if matters are not satisfactory, assurance providers will only be able to gain
sufficient assurance by a full count at the year-end)
Assuming a full count is not necessaryat the year-end, compare the listing of inventory with the
detailed inventory records, and carryout otherprocedures(cut-off, analytical review) to gain further
comfort
2.2 Cost vs NRV
Management should compare cost and net realisable value for each item of inventory. Where this is
impracticable, the comparison may be done by group or category.
Net realisablevalue is likely to be lessthan cost when there has been:
• An increase in costs or a fall in sellingprice
Physical deterioration
• Obsolescence of products
• A marketing decision to manufactureand sellproductsat a loss
Errors in production or purchasing
For work in progress, the ultimate selling price should be compared with the carrying value at the
year-end plus costs to be incurred aftertheyear-end to bring work in progress to a finished state.The
example below shows the testcarried out to identify whether NRV is lower than cost.
Worked example: Audit of inventory
Rajeevis carrying out the audit of inventoryat Icket Ltd. Icket produces various lines of tableware on
behalf of high street stores. It also sells tableware to wholesalers and has a small retail outlet. Icket is not
entitled to sell branded products to wholesalersand it makes approximately 10% more inventory Of
branded products than ordered to ensure it meets quality control standards of the stores. This is
thereforeobsolete once sales of a line to a storeare finished. Each high street store has an allocated sales
manager at Icket who keeps records Ofwhat sales have been made of each line and when the line is
218 Assurance
coming to an end. One high street store customer,Argus, maintains a store of approved inventory at
Icket's premises, which it calls off as required. Icket carried out an annual inventory count at the year-
end.
The key issues for Rajeevwhen auditing inventory are:
• To ensure that obsolete inventory is not included at full cost in the financial statements
• To ascertain that inventory included in the financial statementsexists and that all existing and
valuable inventory is included, including the inventory held at the retail outlet
• To ensure that inventory belonging to Argus is not included in the financial statements
• To ensure that inventory is held at the appropriatevalue in the financial statements
Existence
Rajeev will:
Obtain a copy of the count instructionsissued to employeesof Icket and review them to assess
whether controls over the count appear strong enough to ensure that the correct amount of
inventory will be reflected in the financial statements
Assess the key issues arising at the count; for instance, what the high value inventory is, what the
risks are (outlined above), or whether there are any specific issuesthat will make counting complex
(not in this case)
Plan his count attendance, including sample sizes and target inventory lines
Attend the inventory count, at which he will carry out sample counts to ensure that the counters
are counting properly, the instructionsare being adhered to, proceduresfor obsolete and damaged
inventory are being followed, Argus inventory is properly separated and noted, and to gain an
overall impression of the level and state of the inventoriesand conclude whether the count has
been carried out properly
Trace a sample of items on the final inventory sheets back to original count documents and ensure
all count documents are reflectedin the final sheets
Completeness
Rajeev will:
Follow up items sampled at the inventorycount to ensurethat they are included in the final
inventory sheets, and therefore the financial statements
Follow up Argus items sampled at the inventory count to ensurethat they are not included in the
final inventory sheets, and therefore the financial statements
Carry out a 'cut-off test, ensuring that year-end deliveriesand sales have not been double counted
or not counted (for example, by including an item in inventoryand in sales, or by excluding a
consignment of goods received from inventory and purchases). This will be done by selecting the
goods inwards and outwards notes on either side of the year-end and tracing them to invoices,
ledgers and inventory sheetsto ensurethey are recorded correctly
Rights and obligations
Rajeev will:
Send a confirmation letterto Argus, asking them to confirm the levelof inventory held at Icket on
the year-end date
• Compare the answer to this letterto Icket's records,and, if necessary, reconcile any differences,
liaising with Icket's Argus sales manager. If thereare any substantial differences,this could indicate
a problem with controls over this area of which Rajeevshould inform a senior audit team member
Substantiveprocedures—key financial statement figures
13
219
Valuation
Rajeev will:
• Check that the calculations of valuation on the final inventory sheets have been made correctly
Select samples of raw materials, work in progress and finished goods from Icket's final inventory
sheets
• Ascertain the accounting policy for inventory cost from the financial statements (for example, FIFO)
and confirm it is reasonable and appropriate
• Trace the cost of the raw materialssample to purchaseinvoicesto ensure cost has been recorded
correctly and on the right basis
In addition, forwork in progressand finishedgoods samples,ensure that an appropriate levelof
raw material has been costed, by reviewing production records
• Confirm labour costs allocatedto work in progressand finishedgoods by referenceto production
records and payroll
Review Icket's overhead allocation to ensureonly appropriate costs are included (for example, not
idle time) and performanalyticalprocedurescomparing overheadallocationto previous years
• Compare valuationof cost for finishedgoods sampleto post-yearend selling prices, by reference
to salesorders or invoices, to ensure inventory is held at the lower of cost and NRV
Follow up items noted as obsoleteor damaged at the inventory count to ensure that valuation has
been appropriately adjusted to reflectNRV
For branded goods in excess of customer requirements,ensurethat valuation has been entered as
zero (these goods should be identifiable from sales manager's records)
Interactive question 2: Inventory
Which one of the following proceduresshould be undertaken to confirm the existence of inventory?
Attendanceat inventorycount
Follow up of inventory count sheetsto final inventory sheets
Trace items of inventory to purchase invoices
Cast the final inventory sheets
See Answer at the end of this chapter.
3 Receivables
Section overview
• Key areaswhen testing receivablesare:
Confirming debt owed by customerswith customers(existence.rights and obligations)
Confirming debt is still likely to be collected (valuation)
The major risksof misstatementof the receivablesbalance in the financial statements are due to:
• Debts being uncollectable(valuation)
• Debts being contestedby customers(existence,rightsand obligations)
Assurance
The objective of assurance tests in respectof receivablesis thereforeto prove that these assertions about
the assets are correct. The following sources of information can be used:
Receivables ledger information
• Confirmations from customers
• Cash payments received after the year end
If the company makes a similar number of sales annually to a fairly established customer base then
analyticalprocedures may give good results.
3.1 Confirmations from customers
When it is reasonable to expect customers to respond, the assurance providers should ordinarily plan to
obtain direct confirmation of receivablesto individual entriesin an account balance. Direct confirmation
of receivables in an audit is covered by ISA (UK) 505 ExternalConfirmations.External confirmations are
not compulsory in an audit of financial statements.
The verification of trade receivablesby external confirmation is a means of providing relevant and
reliable audit evidence to satisfy the objective of checking whether customers exist and owe bona fide
amountsto the company (existence and rights and obligations).
Confirmation should take place immediately after the year end and hence cover the year end balances
to be included in the statementof financialposition. If this is not possibleit may be acceptable to carry
out the confirmation prior to the year end provided that the auditor obtains further evidence relating
to the remainderof the period.
Confirmation is essentiallyan act of the client, who alone can authorisethird partiesto divulge
information to the auditor. If the client refusesto allow the auditor to send a confirmation request, the
auditor shall inquire as to management's reasonsfor the refusaland evaluate the implications on the
auditor's risk assessment. Alternativeaudit proceduresmust be performed. If these do not generate
relevantand reliableaudit evidence or the auditor concludes that management's refusal is unreasonable,
the auditor must communicate with those charged with governance and determine the implications for
the auditor's opinion.
When confirmation is undertaken the method of requesting information from the customer may be
either 'positive' or 'negative'.
• Under the positive method the customer is requestedto give the balance or to confirm the
accuracy of the balance shown or state in what respecthe is in disagreement.
• Under the negative method the customer is requestedto reply only if the amount stated is
13
disputed. This method generally provides lessreliableaudit evidence than the positive method as a
lack of responsecould mean that the customerdoes not disputethe balance, or it could mean that
the customer did not receivethe confirmationrequest,or ignored it.
The positive method is generally preferableas it is designed to encourage definite repliesfrom those
contacted. The risk that customers might replywithout actually confirming the balance can be
mitigated by not providing the balance for confirmation and requesting that the customer fills the
balance in. However, this approach can lead to a lower response rate as it involves more work on the
part of the customer. The negative method should only be used when:
• Assessed risk of material misstatementis low
• The relevant controls are operating effectively
• A large number of small balances is involved
• A substantial number of errorsis not expected
• The auditor has no reason to believethat customerswill disregard the request
The statements will normally be prepared by the client'sstaff, from which point the assurance providers,
as a safeguard against the possibility of fraudulent manipulation, must maintain strict control over the
checking and despatch of the statements.
Precautions must also be taken to ensure that undelivered items are returned, not to the client, but to
the assurance providers' own office for follow up by them.
Substantive procedures —key financial statement figures
Worked example: Positiverequestfor confirmationwith balance provided
MANUFACTURING CO LIMITED
15 SouthStreet
London
Date
Messrs(customer)
In accordance with the requestof our auditors,MessrsArthur Daley & Co, we ask that you kindly
confirm to them directlyyour indebtednessto us at (insertdate) which, according to our records,
amounted to E as shown by the enclosed statement.
If the above amount is in agreement with your records, please sign in the space provided below and
return this letterdirect to our auditors in the enclosed stamped addressed envelope.
If the amount is not in agreement with your records, please notify our auditors directly of the amount
shown by your records, and if possible detail on the reverseof this letterfull particulars of the difference.
Yours faithfully,
For Manufacturing Co Limited
Reference No•
(Tear off slip)
The amount shown above is/isnot * in agreement with our records as at (insert date)
Account No Signature
Date Title or position
*The position according to our records is shown overleaf.
Notes
• The letter is on the client's paper, signed by the client.
• A copy of the statementis attached(although thatwill not always be the case).
• The reply is sent directly to the auditor in a pre-paid envelope.
Assurance providerswill normally only contact a sample of customers although it must be based upon a
complete list of all customers. In addition, when constructing the sample, the following classes of
account should receivespecial attention:
• Old unpaidaccounts
• Accounts written off during the period under review
• Accounts with credit balances
• Accounts settled by round sum payments
Similarly, the following should not be overlooked:
• Accounts with nil balances
• Accounts that have been paid by the date of the examination
Assurance providerswill have to carry out further work in relation to those receivables who:
• Disagree with the balance stated (positiveand negativeconfirmation)
• Do not respond (positiveconfirmationonly)
In the case of disagreements, where the customer balance was stated, the customer response shouldhave identified specific amounts that are disputed.
Assurance
Reasons föq 4isagweements
There is a dispute between the client and the customer. The reasonsfor the dispute would have to be
identified, and specific allowances for receivablesmade if appropriate against the debt.
Cut-off problems exist, because the client recordsthe following year'ssales in the current year or
because goods returned by the customerin the currentyear are not recorded in the current year. Cutoff
testing may have to be extended.
The customer may have sent the monies before theyear-end, but the monies were not recorded by
the client as receipts until after the year-end. Detailedcut-offwork may be required on receipts.
Monies received may have been posted to the wrong account or a cash-in-transit account. Assurance
providersshould check if there is evidence of other misposting. If the monies have been posted to a
cash-in-transit account, assurance providersshould ensurethis account has been cleared promptly.
Customers who are also suppliers may net off balances owed and owing. Assurance providers should
check that this is allowed.
Teeming and lading (stealing moniesand incorrectlyposting otherreceiptsso that no particular
customer is seriously in debt), is a fraud that can arisein this area. If assurance providers suspect
teeming and lading has occurred, detailed testing will be requiredon cash receipts, particularly on
prompt posting of cash receipts.
When the positive request method is used the assuranceproviders must follow up by all practicable
meansthose customerswho fail to respond. Second requestsshould be sent out in the event of no
reply being received within two or threeweeks and if necessarythis may be followed by telephoning the
customer, with the client's permission.
After two, or even three, attempts to obtain confirmation, a list of the outstanding items will normally
be passed to a responsible company official, preferablyindependent of the sales accounting
department, who will arrange for them to be investigated.
Where their confirmation is carried out before the year end, assurance providers will have to reconcile
the balance agreed to the year-end balance by reviewing ledger records, invoices and receipts.
All confirmations, regardless of timing, must be properly recorded and evaluated. All balance
disagreements and non replies must be followed up and their effecton total receivablesevaluated.
Differences arising that merelyrepresentinvoices or cash in transit (normal timing differences)
generally do not require adjustment, but disputed amounts, and errorsby the client, may indicate that
further substantive work is necessaryto determinewhether materialadjustments are required.
3.2 Alternative proceduresto verify existence/rightsand obligations
If it proves impossible to get confirmations from individual customers, alternative procedures must be
performedwhich may include the following.
Plan: Recewables—alternative procedures
Check receipt of cash afterdate
Verify valid purchase orders, although thesewill not necessarilyhave led to an invoice
Examine the account to see if the balance outstanding representsspecific invoices and confirm their
validity to despatch notes
Obtain explanations for invoices remaining unpaid aftersubsequentones havebeen paid
Check if the balance on the account is growing, and if so, why
Test companys control over the issueof credit notes and thewrite-off of irrecoverable receivables
Substantiveprocedures—key financial statement figures 223
3.3 Irrecoverable receivables
A significant testof irrecoverablereceivableswill be reviewingthe cash received after date.This will
provide evidence of collectabilityof debts (and hence valuation). It also provides some evidence of
correctness of title (rights and obligations), although ideally it should be carried out as well as a
receivablesconfirmation (the main teston rights and obligations as outlined above).
3.4 Other receivables
A company may also have other receivables,such as royalties.It should be possible to verify such items
to third party evidence, such as correspondencefrom the relevantpartner, or by cash received after
date.
Worked example: Audit of receivables
Sajeeda isworking on the audit of GeneralStationeryplc (GSP), a company that sellsa large rangeof
standard stationery itemsto businessesby mail order. GSP has a large receivables ledger. Although GSP
has many establishedclients, it also receivesa number of one-offor short-termcustomers, as some
companies tend to shop around for the bestdeals on stationeryat the time. GSP's controls over new
customersand salesordersare good in principle, but controls testing has revealed weaknesses in their
operation. In addition, some problemswith goods despatch and invoicing were also discovered during
controls testing. It has been concluded that substantialtestsof detail are required in this area with quite
a large sample of customeraccounts being taken.
The major risks of misstatement of GSP's receivables balance arise from:
• Customers disputing the balancesdue to requestedcreditsand general problems with recording
sales on customeraccounts
• There being a high instanceof irrecoverablereceivables
Completeness
Sajeeda will:
• Obtain a listingof receivables,and ensurethat it castscorrectlyand agreeswith the receivables
balancein the financialstatementsand the salesledger control account total in the nominal ledger
• Check a sampleof customerson the listagainstthe individualsalesledger accounts
Rights and obligations/existence
Sajeeda will:
Select a sampleof receivablesbalancesand carryout confirmationproceduresat the year end,
using the positiveapproach, providing a statementof the customer'saccount
Follow up repliesappropriatelydepending on theircontent
Valuation
Sajeeda will:
• Obtain an analysisof aged debt at theyear end from receivablesledger records and reviewit for
debt in excess of GSP's publishedcreditterms
• Carry out an analysisof after-datereceiptsto observewhetherany old debt remains outstanding at
audit date
If so, collatea listof old debt asyet unpaid and compare the resultsof any confirmation repliesthat
arecovered by the list
• Cross-refer her list to any list of debt written off in the financial statements
• Discuss old debts not written off with the credit controller to see what steps GSP has taken to
recoverthe debt
224 Assurance
Consider whether any of the debt requireswriting off in the financial statements.This amount
should be entered on a list of potential adjustments. If material,it should be referredto senior audit
team members
It is the middle of the final audit visit to GSP. Sajeedahas received54 out of 56 repliesto her
confirmation requests.Of these replies, 30 agree the balance stated and 24 dispute the balance.
Customers who have not yet repliedhavebeen sent threereminderseach.
Sajeeda will:
Pass the two outstanding requests to a senior official unconnected with sales for further follow up
Performreconciliationson the 24 disputed balances,using the informationgiven on the reply and
the information available in the salesand receiptsrecordsof GSP
Of the 24 disputes, Sajeeda finds that 10 relateto timing differenceswith regard to receipts.She
confirms that all of these receiptsclear GSP's bank within reasonabletime afterthe year end by checking
the paying in recordsand bank statements.She can conclude that these10 accounts arefairlystated.
The remaining 14 havedifferencesresultingfrom requestedcredits,fordamaged goods (somegoing
back over six months), for invoicesin relationto which therewere no goods deliveredand for invoices
relating to differentcustomers.
Sajeeda will:
Discuss the requestedcreditswith the appropriatesalesmanager to determinewhy credits have
not been issuedand form an opinion as to whetherthesedebts and relatedsalesmay need writing
off
Trace invoices disputed due to lack of goods delivered,try and trace back to despatch notes to
ascertainwhether GSP statesthe goods were deliveredand form an opinion as to whether these
debts and related sales may need writing off
• Consider the implicationsin termsof inventorymovementsif goods are being invoiced but not
delivered —is inventory overstated; is a fraud being carried out where goods are being stolen?
Refer to copy invoices to confirm whether invoices were in fact sent to the wrong customers. These
errors,while indicating a lack of control over invoicing, do not affectthe overalltotalof receivables,
as they are genuine sales to other customers
Sajeeda should:
• Highlight to senior audit team members that substantive testing has confirmed conclusions that
controls in the area have been ineffective and proved that there is a problem with the receivables
balance, and that the sample may have to be extended and further substantive tests carried out in
this area
Interactive question 3: Audit of receivables
Which one of the following procedures should be undertaken to confirm the rights and obligations of
trade receivables?
Review of cash received after date
Tests of controls over ordering
Receivables external confirmation
Recalculation of specific allowance for doubtful debts
See Answer at the end of this chapter.
Substantive procedures —key financial statement figures 225
4 Bank
Section overview
Keyareas when testing the statement of financialposition bank figure ace:
Confirming bank balancesdirectlywith the bank (existence,valuation, rights and
obligations)
Confirming reconcilingdifferencescalculatedby the client are reasonable(completeness,
valuation)
Confirming any materialcash balances held at the client arc correctly stated (valuation)
The major risksof misstatementof the bank and cash balance in the financial statements are due to:
• Not all bank balancesownedby theclientbeing disclosed(rightsand obligations/existence)
Reconciliation differencesbetweenbank balance and cash book balance being misstated
(valuation)
• Materialcash floats being omitted or misstated (completeness/existence)
The objective of tests in respect of bank is therefore to prove that these assertions about the assets are
correct.The following sourcesof informationcan be used:
• Cash book
• Confirmation from the bank
Bankstatements
Bank reconciliation carried out by the client
4.1 Direct confirmation with bank
Testing of bank balanceswill need to covercompleteness, existence, rights and obligations and
valuation. All of theseelementscan be testeddirectly through the device of obtaining third party
confirmations from the client'sbanks and reconciling thesewith the accounting records, having regard
to cut off. The assuranceprovidersshould update detailsof bank accounts held.
The form and content of a confirmation requestletter(bank letter)will depend on the purpose for
which it is required and on local practices.
The most commonly requestedinformationis in respectof balancesdue to or from the client entityon
current, deposit, loan and other accounts. The requestlettershould providethe account description
number and the type of currency for the account.
It may also be advisable to requestinformationabout nil balances on accounts, and accounts which
were closed in the twelve months prior to the chosenconfirmationdate. The client entity may askfor
confirmation not only of the balanceson accountsbut also, where it may be helpful, other information,
such as the maturityand interestterms,unused facilities,lines of credit/standby facilities,any offsetor
other rights or encumbrances,and detailsof any collateralgiven or received.
The client entity and its assurance providers are likely to request confirmation of contingent liabilities,
such as thosearising on guarantees,comfort letters,bills and so on.
Banks often hold securities and other items in safe custody on behalf of customers. A request lettermay
thus ask for confirmation of such itemsheld by the confirming bank.
The procedure is simple but important.
(a) The banks will requireexplicit written authority from their client to disclose the Information
requested.
(b) The assurance providers' request mustrefer to theclient's letter of authorityand the date
thereof. Alternatively it may be countersigned by the client or it may be accompanied by a specific
letter of authority.
226 Assurance
(c) In the case of joint accounts, letters of authority signed by all parties will be necessary.
(d) Such letters of authority may either give permission to the bank to disclose information for a
specific request or grant permission for an indeterminate length of time.
(e) The requestshould reach the branch manager at leasttwo weeks in advance of theclient'syearend
and should state both that year-end date and the previous year-end date.
(f) The assurance providers should themselves check that the bank response covers all the
information in the standard and other responses.
4.2 Bank reconciliation
Care must be taken to ensure that there is no window dressing, by checking cut off carefully. Window
dressing in this context is usually manifestedas an attempt to overstatethe liquidity of the company by:
(a) Keeping the cash book open to takecredit for remittances actually received afterthe year-end,
thus enhancing the balance at bank and reducing receivables,as cash is more liquid than debt.
(b) Recording cheques paid in the period under reviewwhich are not actually despatched until after
the year-end, thus decreasing the balance at bank and reducing payables. This can contrive to
present an artificially healthy looking current ratio.
With the possibility of (a) above in mind, where lodgements have not been cleared by the bank until the
new period, the assurance providers shouldexamine the paying in slip to ensurethat the amounts
were actually paid into the bank on or before the end of the reporting period.
As regards(b) above,wherethereappearsto be a particularlylarge number of outstanding cheques
at the year-end, the assurance providers should check whether thesewere cleared within a
reasonable time in the new period. If not, this may indicate that despatch occurred afterthe year-end.
4.3 Cash count
Planning is an essentialelement of cash counts, for it is an important principle that all cash balances are
counted at the same time as far as possible. Cash in this context may include unbanked cheques
received, IOUs and credit card slips, in addition to notes and coins. Often such cash balances are
unlikely to be material, but in certain businessesthey may be.
As part of their planning proceduresthe assurance providers will hence needto determinethe
locations where cash is held and which of these locations (if any) warrant a count.
Planning decisions will need to be recorded on the current audit file including:
• The precise time of the count(s) and location(s)
• The names of the audit staff conducting thecounts
• The names of the client staff intending to be presentat each location
Where a location is not visited it may be expedient to obtain a letterfrom the client confirming the
balance.
The following mattersapply to the count itself.
All cash/petty cash books should be written up to date in ink (or other permanent form) at the
time of the count.
All balances must be counted at the same time.
• At no time should the assurance providers be leftalone with the cash and negotiable securities.
• All cash counted must be recorded on working paperssubsequentlyfiled on the currentaudit file.
Reconciliations should be prepared where applicable (for example imprest petty cash float).
Substantive procedures—key financial statement figures 227
Worked example: Audit of bank
D Tracey is working on the audit of the bank reconciliationat IT Limited (ITL), a computer systems
company. She has obtained the following bank reconciliation.
BANK RECONCILIATION AT 31 DECEMBER20X6
Balance per bank statement
Less unpresented cheques
Cheque number
13539
13540
13542
13543
13544
13545
13546
Bal c/f
(24,933)
(54,388)
(64,420)
(3,492)
(1,849)
(53,944)
(940)
Add outstanding lodgements
Date in cash book
27.12
28.12
31.12
31.12
355
103,344
39,455
5,301
Balance per financial statements
79,938
(203,966)
(124,028)
(124,028)
148,455
24,427
The bank letter confirmed the balance per bank given in the bank reconciliation.
Tracey will:
Trace unpresented cheques to bank statements after the year end to confirm what date they
cleared the bank
Reviewpaying in books and bank statementsin respectof the lodgements, to see what date they
were paid into the bank
Enquire why a substantial lodgement remained unbanked for three days prior to the year end
Interactive question 4: Bank balance
Which one of the following will be confirmed by obtaining a bank letterfrom a specific bank?
That the bank balance statedon the bank reconciliationis correct.
That the unpresented cheques listed on the bank reconciliation were sent out pre year-end.
That the company possessesonly the bank accounts it declares.
That the cash floats of the company are fairly stated.
See Answer at the end of this chapter.
228 Assurance
5 Payables
Section overview
• Key areaswhen testing payablesare:
Ensuring that all liabilitiesare included (completeness)
Confirming that all liabilitiesare bonafideowed by the company (rights and obligations)
The major risks of misstatementsof payables in the financial statementsare due to:
• The entity understating its liabilitiesin the financial statements(completeness)
Cut-off between goods inward and liabilityrecording being incorrect(cut-off)
• (More rarely)non-existent liabilitiesbeing declared(existence, rights and obligations)
The objective of testsin respect of payables is thereforeto prove that these assertionsabout the
liabilitiesare correct. The following sources of informationcan be used:
Payables ledger records
• Confirmationsfrom suppliers
Analytical procedures could point to understatementif the account balance is inexplicably reduced from
previous years.
5.1 Supplier statements
The most important testwhen considering trade payables is comparison of suppliers'statementswith
payables ledger balances.
When selecting a sample of payablesto test, assuranceprovidersmust be careful not just to select
supplierswith largeyear-end balances. Remember,it is errorsof understatement that assurance
providersare primarilyinterestedin when reviewingpayables,and errorsof understatement could occur
equally in payables with low or nil balancesas with high.
Whencomparing supplier statements withyear-end payables ledger balances, assuranceproviders
should include within their sample payables with nil or negative payables ledger balances. Assurance
providersshould be particularlywary of low balanceswith majorsuppliers. Remember the client has no
incentive to record liabilitiesbeforebeing invoiced. The sample should be selected from the client's list
of suppliers, not the payables ledger.
You may be wondering, as we normallycarry out a circularisationconfirmationof receivables,whether
we would also circularisesuppliers.The answeris generally no.
The principal reasonfor this lies in the natureof the purchasescycle: third party evidence in the form of
suppliers' invoices and, even moresignificantly, suppliers' statements, are part of the standard
documentation of the cycle. The assuranceproviderswill hence concentrateon these documents when
designing and conductingtheirtests.
In the following circumstances the assuranceprovidersmay, however,determine that a confirmation is
necessary. In these cases confirmation requestsshould be sent out and processed in a similar way to
accounts receivable confirmation requests.'Positive'replieswill be required where:
Suppliers' statements are, for whateverreason,unavailable or incomplete.
• Weaknesses in internal control or the natureof the client's business make possible a material
misstatement of liabilitiesthat would not otherwisebe picked up.
It is thought that the client is deliberately trying to understate payables.
• The accounts appear to be irregular or if the natureor size of balances or transactions is
abnormal.
Substantive procedures key financial statement figures 229
5.2 Other payables/accrued expenses
Companies may have other payables and the testscarried out on them will vary according to what the
nature of that account is. Rememberthat you are primarily testing for understatement. Consider
whether you can obtain third party evidence about the balance. You may have to think laterally about
the specific balance.
An accrual is a type of payable,and is made when an expense has been incurred in the current period,
but will not be paid for until the next period.Typically, an accrual is made when a company not only
has not paid for the item, but has not even receivedan invoiceat the period end. In order to include
theseexpenses the company drawsup a listof accruals.Examples of accruals include recurring items,
such as utility expensesand bank interest,as well as one-offssuch as the audit fee.
The amount of some accruals may be known precisely, but in some cases the amount to accrue has to
be estimated. In caseswherethe invoicecoversa periodstraddling the year end, it may be necessaryto
prorate an expense, ie to accrue for only the proportion of the expense which falls before the period
end (eg the two months of a three-monthphone bill which relatesto the reporting period).
The audit of accrualsfocusesprimarilyon cut-off and completeness. Here, cut-off means that the
amount accrued relatesto the reporting period, eg that two months of the three-month phone bill have
been accrued(up to the periodend) ratherthan two and half months, which would be inaccurate. Cutoff
can thereforebe tested by the auditormaking her own estimateof the accrual and comparing this
with the amount accrued by the entity.
Completeness means that no accruals have been missed.This can be tested by reviewing the entity's
purchase invoices receivedafterthe period end. Any invoices which relate to the reporting period
should be accruedfor.
Worked example: Audit of payables
Ugo is working on the audit of payables at SeriouslyDodgy Limited (SDL). He has carried out analytical
procedureson the payables balance, comparing it with prior years, month by month balance owing
levels,levelsof purchasesduring theyearand the change in inventorylevelsfrom beginning to end of
the year.
Ugo has enquired about obtaining supplier statements at the year-end, and the payables ledger clerk
has directed him to a file where they are kept. She tells him that not all the suppliers send statements, so
they only reconcile the ones they get. Ugo confirmsthis with the audit file from the previous year. On
examination of the file, however, Ugo notesthat at leastthree suppliers which sent statements lastyear
have apparently not sentstatementsthisyear. In addition, SDL has started major accounts with three
new suppliersin theyear, none of which has sent a statement.
As a resultof this, and the resultsof his analytical procedures,which indicate that there may be a
discrepancy betweenthe levelof purchasesand the published payables at the year end, he suspectsthat
SDL may be trying to understatepayables.
Ugo thereforealertssenior audit staffmembersto his suspicions and makes a recommendation that a
supplier circularisation be carried out as a one-off exercise.
Assurance
InteractivequestionS' Auditof payables
Indicate whether the followtnq qtatemenl%are true or
(a) Supplier statements are a strong of ev•denceas they are third party
evidence however. as the assurance provider receivesthem through the
medium of the client. the assurance provider must treat suppliet
statementswith professionalscepti(ism
(b) Payables may be testedby cash payments afterdate as thesegive an
indication that debts were owed and the value of those debts has not been
understated.
See Answer at the end of this chapter.
6 Long-term liabilities
Se«ion overview
• Risks include failure to make correct disclosures and miscalculation of interest.
• Thee be third party evidencefromlender.
We are concemed herewith long-term liabilitiescomprising debentures,loan stock and other bats
repayable at a date more than one year after the year-end. The majorrisksof misstaterænt 10"9term
liabilities are:
• That not all long-term liabilitieshave been disclosed(completeness)
• That interestpayable has not been calculated correctlyand included in the correctaccmmting
penod (accuracyand cut-off)
• That disclosure is incorrect(presentationand disclosure)
A complication for the assuranceprovider is that debentureand loan agreements
conditions with which the company must comply, including restrictionson the convy's tow
borrowings and adherence to specific borrowing ratios.
The following sources of information exist:
• Schedule of loans/prior year audit file information
Statutory books, such as register of debentures, articles ot association
Loan agreements
Bank letter and direct confirmations trom other lenders
• Cash book
• Board minutes
• Client schedulesand calculations
Accounting policies in the financaalstatements
OMain/prepare schedule of loans outstandbnyat the
loan name 01lender,date loan.matuntydate, gue•ot du. tae,
penod and secunty
Compareopo•ing bdances to previousyen
Test the dericai accuracy the analysts
balances to led9U
tu exh
ot ttæ
231
Plan: liabilities
Check name of lender etc, to register of debenture holders or equivalent(if kept)
Trace additions and repayments to entries in thecash book
Confirm repayments are in accordancewith loan agreement
Examine cancelled cheques and memoranda of satisfaction for loans repaid
Verify that borrowing limits imposed either by Articlesor by other agreements are not exceeded
Examine signed Board minutes relatingto new borrowings/repayments
Obtain direct confirmation from lenders of the amounts outstanding, accrued interestand what
security they hold
Verify interest charged for the period and the adequacy of accrued interest
Confirm assets charged havebeenentered in the register of charges and notified to the Registrar
Review restrictive covenants and provisionsrelatingto default:
• Review any correspondence relatingto the loan
• Review confirmation repliesfor non-compliance
If a default appears to exist, determine its effect, and schedule findings
Review minutes, cash book to check if all loans have been recorded
7 Income statement items
Section overview
• A key area when testing income statement items is completeness.
7.1 Revenue
It was stated in Chapter 6 that revenuewill often be tested by testing controls. Subsequent testing on
revenue will usually involve analytical procedures, as revenue is the area of the business the company is
most likely to have information and analysis about. In addition, revenue has predictable relationships
with other items in the financial statements, notably receivables,about which it is possible to obtain
strong third party evidence as outlined above.
Revenue can also be tested by vouching individual transactions. If the major risk with revenue at a
particular client is that it is overstated, this would involve selecting individual items of revenue recorded
in the nominal ledger and tracing back to source documents, such as sales invoice, then despatch notes.
7.2 Purchases
As noted in Chapter 7, purchasesareoften tested by testing controls in that area. Additional or alternative
substantive procedureswill often include the useof analytical proceduresdue to the strong relationships
that purchaseshas with other itemsin financial statements,notably inventory and payables.
In addition, individual transactionscan be tested,commencing with goods received notes and tracing
transactions through the system to ensure completeness.
7.3 Payroll costs
Analytical procedures are often carried out on payroll costs as there are strong relationships between
numbers of staff, pay ratesand overall costs and also tax/Nl ratesand pay.
Tests of details to verify if payroll costs might include checking for a sample of payroll records that time
worked has been correctly included (to clockcards), employees exist (personnel records) and are being
paid at the correct rate (contracts/personnel records) and that the payroll is calculated correctly (by
reperforming calculations).
Payments from the payroll to staff and tax authorities can be verified to bank statements. Postings from
the payroll to the nominal ledger should also be checked.
232 Assurance
7.4 Interest paid/received
Interest paid/received can usually be tested by inspecting bank statements, or confirmations from other
lenders.
7.5 Expenses
Other expenses in the income statementcan be testedby analyticalprocedures,and also by vouching
specific transactions to purchase invoices.
7.6 Summary of matters which should be reported to more senior staff
The following table applies to any of the areasof the financialstatementscovered in this chapter, and
gives examples of matterswhich should be reportedto more seniorstaff.
Matters which should be referred to a senior member of staff
Conclusions of audit procedures performed.This is crucial if the conclusion is negative, eg that controls
in the area being testedare ineffective.
Exceptional items discovered when performing procedures,eg transactionsoutsidethe normal course
of business, and transactionsabove or below marketrates.
Any unusual accounting entriesnoticed.These could be misstatements,or may be subject to different
reporting requirements, eg relatedparty transactions.
Any indications of possible money laundering. It may be necessaryfor thejunior to reportthe matter
to the firm's MLRO ratherthan to moreseniorstaff.
Issueswhich need to be discussed with the client. Differentfirmshavedifferentnorms here;in some it
is usual for the junior member of staffto discuss issueswith the client staff,but in othersthis would
always be done by a senior member of staff.Juniorstaffshould generally behave in accordance with
their firm's expectations, referring matters up to senior staff as appropriate.
Where the junior member of staffdiscussesissuesdirectlywith the client staff,the client's responses
should be clearly recorded in the audit file. If theseresponsesappear unclear or ambiguous, this should
be raisedand discussed with a senior memberof staff.
Anything which the junior member of staffis unsure about or does not understand. It may not be
always necessary to raise an exception on the audit file, so the mattershould first be discussed with
more senior staff.This is important both for thejunior'sprofessionaldevelopmentand also because it
may be that they do not understand the matterbecauseit containsa misstatement.
Substantive procedures—key financial statement figures
13
233
Summary and Self-test
Summary
Non-current assets
Key issues:
Existence, rights and obligations,
completeness, valuation
Sources of information:
Third party valuations,invoices,
auditor inspection (strong)
Client schedulesand calculations(not
so strong)
Receivables
Key issues:
Rights and obligations,valuation
Sources of information:
Third party confirmations,cash
paymentsafter date (strong)
Bank
Key issues:
Completeness, existence, rights and
obligations, valuation
Sources of information:
Confirmation from bank,bank
statements (strong)
Client schedules,reconciliations(not
so strong)
Inventory
Key issues:
Existence,valuation
Sources of information:
Auditor attendance at count, invoices,
third party confirmations (strong)
Client controls over count, client
production schedules (not so strong)
Payables
Key issue:
Completeness
Sources of information:
Supplier statements (strong, but open
to tampering by client)
Long-term liabilities
Key issues:
Completeness, accuracy, disclosure
Sources of information:
Loan documentation,statutory books,
confirmationsfrom lenders (strong)
Client schedules,board minutes,client
calculations(not so strong)
Income statement
Key issue:
Completeness
Assurance