SUBSTANTIVE TESTING Notes

AUDIT PLANNING, CONTROL & RECORDING (iSA 300) NOTES

What is SUBSTANTIVE TESTING?

Substantive tests are those tests carried out by auditors to confirm the assertions of the management. These assertions include: existence, rights and obligations, occurrence, completeness, valuation, measurement and presentations and disclosure.

They are tests to detect material misstatements in the financial statements.

DEFINITION OF KEY TERMS

Cut-off tests

which involve selecting goods, received notes raised before the year-end and ensuring that the related invoices have been included in the purchases daybook before year-end as well as individual creditors’ accounts. if no invoices have been received to match those goods received notes than a reasonable liability should have been set up.

DEBTORS’ CIRCULARIZATION

This is a procedure by which the auditor obtains corroborative evidence regarding the existence,ownership and the value of debtors appearing in the financial statements. This is done by writingdirectly to the debtors and requesting written confirmation to be sent directly to the auditor.

Post Balance Sheet Events- This involves transactions that are entered into before the balance sheet date with the sole purpose of altering the appearance of the balance sheet.

INDUSTRY CONTEXT SUBSTANTIVE TESTING

The auditor always encounters substantive testing during the audit where he tests debit items for overstatement and credit items for understatement. Therefore this is an important area for the auditor for him to obtain sufficient appropriate evidence to support the financial statement assertions.

Substantive Tests

Compliance tests provide the auditor with indirect evidence, the auditor therefore cannot on the strength of compliance test alone reach a conclusion as to whether or not a balance is fairly stated. The auditor therefore carries out substantive testing to obtain more assurance on the reported balances.

Substantive tests are those tests balances and transactions and other procedures such as analytical review, which seek to provide audit evidence as to the completeness and accuracy and validity of information contained in the records and or the financial statements. Substantive tests are those tests carried out by auditors to confirm the assertions of the management i.e. existence, rights and obligations, occurrence, completeness, valuation, measurement and presentations and disclosure.

Exceptions of substantive tests

In substantive tests transactions speak for themselves therefore any error or deviation is measured for its materiality or effect on the financial statement or the recorded balance.

Compliance test give indirect evidence to the auditor and if the conclusion from them id positive then it assures the auditor that there were measures in place to minimize misstatements. This then reduces the extent of detailed substantive testing. It is possible to carry out a purely substantive audit and make a valid conclusion without any reliance on any internal controls.

After the substantive test the auditor can conclude that proper records have been kept and that the accounting system is adequate and is a reliable basis for the preparation of financial statements.

Directional Tests:

A general assumption that audit firm have is that companies overstate assets and understate liabilities. It is also has to do with double entry system e.g. creditors and purchases. if one is correct then most likely the other is correct also.

The techniques used are:

Review payments after balance sheet date and matching them against related invoices specifically noting dates on invoices to ensure that the invoice was accounted for in the correct accounting period.

Cut-off tests which involve selecting goods, received notes raised before the year-end and ensuring that the related invoices have been included in the purchases daybook before year-end as well as individual creditors’ accounts. If no invoices have been received to match those goods received notes than a reasonable liability should have been set up.

Comparison of the present list of creditors with the previous year’s list and investigations being carried out on those creditors on the list of the previous year missing from current years list to confirm that they are properly excluded through settlement during the year under review.

Reviewing reconciliation of creditors’ statements with the creditors’ individual ledger accounts ensuring that any reconciling items are valid and genuine.

Reviewing lending contracts or agreements for breach of contract accusations to determine where claims would be made against the company.

Reviewing correspondence with professional advisers e.g. lawyers for claims that they may have made against the company but not recorded. Balance sheet ratios that are usually considered :-

Fixed Assets (FA):

The utilization of Fa’s is usually worked out. This is:

Turnover

Fa (nbv)

To determine how much sales are generated for every shilling invested in Fa’s. it is normally called the Fa turnover ratio.

Global depreciation ratio is worked out which involves taking the nbv of the Fa’s divided by the depreciation charge in the profit and loss account. The resultant figure gives a rough estimate of the average remaining useful life if the assets. Too big a figure indicating that maybe the rates of depreciation used are too low.

Stocks:

The percentage increase is calculated and is compared with the corresponding percentage increases in purchases. if the two increases do not correspond, it may indicate that the provision for obsolescence is inadequate.

The stock turnover ratio is also worked out. To ensure that we’re comparing like with like, the cost of sales figure is used and not the sales figure. A slowing down turnover ratio may also indicate that the provision for obsolescence is also inadequate therefore it would appear that the demand for the products of the organization may be diminishing.

Debtors:

The percentage increase in debtors is worked out and this is compared with the percentage increase in turnover. it is usually being expected that an increase in turnover ordinarily should have a corresponding increase in debtors. Debtors to sales ratio is also worked out to determine the number of day’s sales are debtors. This number of days is compared with the normal allowed credit period. it measures the effectiveness of credit control and consequently the adequacy provision for bad and doubtful debts.

Liquidity ratios are then worked out The most common of which are:

i. The current ratio ii. The acid test ratio

For cash at bank an additional measure is consideration of the overdraft limit for the trade creditors.

The percentage increase is worked out and compared with the increase in the cost of sales.

also the number of day’s purchases in creditors worked out of measure the difference between credit taken and credit allowed by supplies.

The gearing ratio

This is worked out of measure the company’s exposure or the cost of external capital to the organization.

Vouching Audit

Vouching is checking the authenticity of recorded transactions. It is proving that the transactions occurred, they are complete correctly measured and they relate to the correct period if they are of a revenue or expense nature.

Usage of vouching

in very small audits when the number of transactions are not too large.
- in audits whose internal control is weak or non-existent.
- in certain types of specialized audits such as that of trusts or estates.

Method:

The vouching audit involves a consideration of each entry in the books and vouching the available evidence to support each entry. The evidence usually consists of documents and papers and should satisfy the auditor that:

The transaction was authorized by management.
- The transaction came within the aims and objectives of the organization.
- The transaction was correctly and adequately described by the entry in the books.
- The entry is correctly incorporated in the final procedures.

NOTE: The above is the guideline for all vouching procedures.

Practical illustrations interest paid

Ensure that transaction was authorized
1. The authority for payment of interest should be obtained prior to payment. This stems from the authority to acquire the loan.
1. The auditor should examine the minutes of board of Directors (boD) or the minutes of annual General meeting (aGm) for proper authorization to obtain the loan and to service it. The authorization should be expressly indicated and it should refer to the loan in question and differentiate it from any other.
Ensure that the transaction came within the aims and the objects of the organization.

The auditor should check the reason for obtaining the loan(s) and ensure that they are in accordance with the aims of the organization.

obtain the loan agreement and check for:

Amount
- Interest
- Period for interest to be paid
- Any other matters of default none should be prejudicial to the shareholders interest.
Ensure the transaction was correctly and adequately described by the entry in the books.
- Re-compute the interest and ensure it is correctly calculated.
- Check the recording of this interest in the ledger.
- Obtain the counterfoils of the cheques paid for this interest.
- Trace the item in the bank statement.
Ensure entry is correctly incorporated in the final accounts
- Check the amount recorded in the profit and loss account to ensure that item is properly recorded as an expense and it relates to the correct period.
- Check that the amount and date are the correct ones.

Interest received

The auditor should check the investment which has borne such an interest and check the authority for its acquisition. This can be found in the minutes of the boD or the aGm. (This is similar to number one of interest paid.)
The auditor should obtain the investment contract and check:
1. The amount invested
1. The interest or that particular investment
1. The period of investment
1. any other matters
Ensure that this transaction was properly recorded.
1. Compute the interest or the investment
1. Check the recording in the ledgers
1. Check the mode of payments; cash or cheque.
1. Trace item to the bank statement and cashbook.
Ensure that the item is properly reflected in the profit and loss account i.e. that the amount is correct and it relates to the correct period.

Dividend received

Check authority for purchasing the shares because the dividend is received on shares owned. This should be in accordance with the investment policy of the organization.
obtain the registrar of investment check for:
1. number of shares owned
1. rate of dividend
1. Types of shares owned
1. Date of acquisition
1. The auditor can also check press reports that have news on declaration of dividends and their payments.
Ensure dividends received are properly reflected in the accounts and in particular check the cut-off for dividends received.
1. Dividends may relate to the current period but may be received in another financial period do the auditor should ensure that they are recorded in the period they relate to.
1. Check the recording of the shares bought or sold cum-div (with dividend) or ex-div ( without dividend) and ensure that it is properly recorded in the ledgers.
1. Check the mode of payment of dividend and ensure proper recording. Compare the cash book and the bank statement.
1. Check the recording of this item in the profit and loss account.

Rent received

Check the minutes of the BOARD and/ or AGM to ascertain authority for obtaining the property and for renting the property out.
obtain the lease agreement to check for:
1. property rented and the amount of rent
1. The rental period e.g. 10yrs, 20yrs
1. Frequency of obtaining rental payments e.g. monthly, quarterly
1. Terms of maintenance of the property could be maintained by the landlord or tenant
1. Ensure that these are in agreement with the organizations objects
Check the ledgers for proper recording of the rent this refers to both the amount received and the period to which it relates. The auditor should also check the reasonableness of the rent on the rented property. he could do this by getting an opinion of an expert i.e. a valuer.

Trace the item to the cashbook and bank statement

Ensure that the profit and loss account has the correct amount and item is for the correct period.

Vouching audits of different types of business

There are innumerable types of business and all of them have accounts prepared and most of them have their accounts audited. Every type of business has its audit problems but the sheer number different types of business make it impossible to discuss these problems in other than a general way. For exam purposes it is normally possible to apply a general approach to an audit which will conform to the specialized guidelines giving a general knowledge about the enterprise and some imagination.

These guidelines were given at the beginning of this lesson.

Insurance premiums received

This pertains to insurance companies. A premium is money paid to an insurance company to provide a cover against a risk.

Obtain the authority for accepting the cover. This should be from the appropriate official and if necessary from a board resolution.
obtain copies of the policies given and check various insurance covers

Date when insurance premiums are due penalties for default

These should be in accordance with the insurance company’s policies regarding insurance covers.

Calculate the premiums and compare this amount to the amount received.
- Check the period which relates t the premiums received and check that the premiums received is correctly shown.
- Check the recording of the premium in the ledgers.
- Obtain copies of standing orders from the insured and ensure that entries therein agree with those in ledgers and check for:
- Schedule of standing order
- Number of polices • Date due
- Any defaults-check the entries in the ledger for this.
Obtain bank reconciliation and compare it to the cash book and check the insurance statement for proper recording of this item.

Subscriptions received

This relates to clubs or non-profit making organizations.

Obtain authority for admitting the members whose subscriptions are being audited. The auditor should obtain the constitution of the club or organization.
The auditor should obtain the constitution of the club and check:
1. maximum number of members and the type of members
1. The subscription from each member
1. provision for default
1. The auditor should then check the actual number of members and the rates they have paid
Obtain the ledger and ensure that subscription paid have been entered properly both in amount and the period to which they relate. He/she should compare the amount in the ledgers with the rates, which should be paid by each member in the various categories.
Obtain the cash book and compare it to the bank statement. Ensure that there is good reason for variances. Check that it is properly recorded in the income statement.

Hire purchase instalments received

Authority from the BOARD minutes or AGM or proper official with the authority for granting hire purchase terms to customers.
obtain hire purchase agreement and check for:
1. value of asset
1. hire purchase price
1. hire purchase instalments
1. provision for default
1. Ensure the hire purchase terms are in agreement with the policy of the organization
Find out the amount of instalments and when they should be paid and get the ledgers recording of these instalments. Ensure that capital payments are separated from revenue payment. The auditor should calculate the amounts and compare them to those that are recorded.
Check the recording of these items in the cashbook and the bank statement to ensure that the two are in agreement. Check the profit and loss for proper recording.

Audit of Salaries and Wages

The audit of salaries and wages is a little different from the audit of other expenses or payments of an enterprise. The difference is that the audit procedures lay emphasis on checking the strength of the internal control system. This therefore means that to carry out a proper audit one should have a very good understanding of the features of a strong internal control system for payment of salaries and wages.

Some of the frauds which can be perpetrated by the employees and which the auditor should look out for include:

Dummy/ghost workers: these are workers who do not exist.
- Fraudulent double payment for employees: this could be done by giving different names for the same person.
- Payment for work not done and unclaimed wages being misappropriated
- Inflating payroll by wrong increments or showing increment when it is not due.
- Improper deductions being made or being misappropriated.
- Manipulation of commission.

The auditor should check the following areas carefully:

Time workers-who come in shifts who work for certain number of hours a day
- Piece workers-employed to do certain job
- The preparation of wages
- The payment of wages
- Dummy workers
- The recording of salaries and wages and also employee records

Audit tests for salaries and wages

Test the internal control system of payment of wages. Check if there is possibility of this system detecting ghost or dummy workers or any similar fraud.
- Check the procedure of employment and dismissal of employees, which should be authorized by a responsible officer.
- verify that there is proper recording of wages.
- For time basis check time records.
- Check authorization of overtime.
- verify authority for deductions and ensure proper recording.
- Check castings of wages.
- Ensure all stages of preparation of payment of wages are properly authorized.
- Check total of wages paid to control account.
- Test a number of entries of payments to employees and ensure that they were received by employees.
- reconcile signature of original employment to that signed on receipt of the wages

Verification of assets & liabilities

Verification is proving the authenticity of a recorded balance. This is achieved through attempting to prove the assertions made by management in preparing financial statements.

iSa 500 paragraph 12 “when obtaining audit evidence from substantive procedures, the auditor should consider the sufficiency and appropriateness of audit evidence from such procedures together with any evidence from tests of control to support financial statement assertions”

The auditor must substantiate all the relevant management assertions for each outstanding account balance. he must obtain evidence that the accounts give true and fair view.