University of New South Wales School of Accounting Auditing and Assurance Services 2010

1. University of New South WalesSchool of AccountingAuditing and Assurance Services2010 LECTURE 6 Tests of Controls and Substantive Analytical Procedures

2. The Audit Process • An Audit consists of 3 basic steps: • Planning • Assessment of business risk • Assessment of the internal control environment • Evidence Gathering and Evaluation • Tests of controls • Substantive tests • Formation of the Audit Opinion

3. This Lecture • This lecture is the second in a three lecture series on the evidence gathering and evaluation phase. • We will cover: • Substantive analytical procedures, • Tests of controls.

4. Audit Evidence • Auditors gather evidence about • The operation of internal controls (Tests of controls). • Financial Balances and Transactions (Substantive testing) • $ amounts • Disclosures

5. Substantive Procedures • There are two types of substantive procedures: • Tests of detail, • Substantive analytical procedures. • They are both equally valid methods of gathering audit evidence about: • $ amounts, • Disclosures.

6. Tests of Detail • The most basic type of audit test is the test of detail. • Tests of detail involve: • Selecting a sample of items. • Testing the items in the sample. • Noting the errors. • Based on these errors making an estimate of the overall error in the account.

7. Substantive Analytical Procedures • The Relevant standard is • ASA 520 Analytical Procedures • For purposes of the Australian Auditing Standards, the term “analytical procedures” means evaluations of financial information through analysis of plausible relationships among both financial and non-financial data. Analytical procedures also encompass such investigation as is necessary of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount. (ASA 520.4)

8. Substantive Analytical Procedures • Substantive analytical procedures involve: • Estimating the balance of an account using mathematical relationships between it and • Other financial information • Depreciation has a mathematical relationship with property plant & equipment • Interest expense has a mathematical relationship with interest bearing liabilities • Non financial information • Production capacity constraints and other physical limitations.

9. Hotel Room Income • ABC Ltd owns a large hotel in the centre of Sydney. • Its trail balance contains a figure of $12.1 million for room income. • Is this correct? • Tests of detail could be used. • Refer to testing sales in previous lecture. • However, substantive analytical procedures will be more efficient.

10. Hotel Room Income • There is a mathematical relationship between room income and non financial information. • Room Income = Number of rooms x Rate per room x Occupancy Rate x 365 • Investigation reveals that the hotel has 200 rooms with a room rate of $250 per night and it is 60% full on average, room income should be • 200 x 250 x 0.6 x 365 = $10.95 m • This is $1.15 m below the reported figure. • Is this a material error? • A more complex calculation is needed.

11. Hotel Room Income • Further examination reveals that the hotel has 20 suites that have a room rate of $400 per night and a 70% occupancy rate. • Ordinary room income • 180 x 250 x 0.6 x 365 = $9.855 m • Suite income • 20 x 400 x 0.7 x 365 = $2.044 m • Total $11.899 m • This is much closer to the reported figure of $12.1 m and indicates that room income is not materially misstated.

12. Interest Expense • Auditing of interest expense • Tests of Details • Select a sample of interest bearing liabilities, check that there are journal entries for the expense (completeness) and that the calculations are correct (accuracy). • Substantive Analytical Procedures • Split the interest bearing liabilities into classes. • Use an average rate for each class to estimate interest for that class. • Sum up these class totals to estimate the overall total.

13. The Milfred Company Ltd - Overall Test of Interest Expense Interest expense as per general ledger 31/12/05 17,539(1) Computation of estimate: Short-term loans: Balance outstanding at month end: (2) Jan 47,500 Feb 59,200 Mar 70,600 Apr 70,800 May 61,200 June 43,700 July 20,000 Aug — Sept — Oct 12,700 Nov 26,400 Dec 35,600 Total 447,700 ====== Average (12) 37,300 @ 14.5%(3) 5,410 Long-term loans: Opening balance 137,500 (2) Closing balance 121,700 (2) ---------- 259,200 ====== Average (2) 129,600 @ 9.7%(4)12,570 Estimated total interest expense 17,980(5) Differences (441) Legend and comments: (1) Agrees with general ledger and working trial balance (2) Obtained from general ledger/verified to bank statements. (3) Estimated based on examination of several notes throughout the year with rates ranging from 14% to 15%. (4) Agrees with permanent file schedule of long-term debt. (5) Difference not significant. Indicates interest expense is reasonable

14. Reliance • Extent of reliance placed on analytical procedures, as substantive procedures, depends upon: • Risk of account misstatement, • Materiality, • Other audit procedures directed to the same objective (and the nature of the account), • Accuracy of analytical procedures, • Evaluation of internal controls.

15. Reliance – Internal Controls • Substantive analytical procedures use mathematical formulae. • The output will only be as good as the inputs. • The input data is often drawn from a company’s internal control system. • In the hotel room example, the occupancy rate will come from the hotel reservation system. • Therefore, substantive analytical procedures are most useful when internal controls are effective.

16. Reliance - Calculations • Substantive analytical procedures use mathematical formulae. • Therefore, there must be something to calculate • i.e. there must be a mathematical relationship • This is often not the case, so substantive analytical procedures are not used for many accounts • Tests of detail can be used for every account and every assertion.

17. Analytical Procedures • Analytical Procedures can be used for • Planning • Evidence gathering • substantive analytical procedures • Review of the audit • Ratios, trend analysis, common size balance sheets etc. can be used for planning and review but they are NOT substantive analytical procedures.

18. Examples • How would you use analytical procedures to estimate the following? • In which cases is the use of analytical procedures inappropriate and why? • Fee income for a private school • The wages bill for UNSW • Sales for Woolworths • Provision for doubtful debts at a bank.

19. Internal Controls and Audit Assertions • Auditors are interested in internal controls because they can reduce potential errors in the financial statements. • If a particular control works, it makes it more likely that a given assertion will be correct. • This means that less substantive testing needs to be carried out for that assertion. • As noted previously,tests of controls are performed to determine if the control is operating effectively. i.e: • The control must exist, • The control must be effective, • The control must be effective during all relevant time periods.

20. Tests of Controls Example • XYZ requires the warehouse manager to conduct these procedures when inventory is received: • Count and compare the count to the order quantity and note any discrepancies, • Check and note any damage, • Immediately transfer to the locked warehouse. • Sign the company’s copy of the order form, indicating that the above procedures have been carried out, • Attach the signed order form to the goods received note and send it to the accounts department.

21. Tests of Controls Example • To test these controls • Check the policy manual to see if they are required • Enquire of the manager and other staff to see if they are carried out in practice • Observe the receipt of inventory to see if the control procedures are carried out • Examine the orders to see if a goods received note is attached and if the order is signed • Observe whether the warehouse is kept locked • These tests must be done throughout the year.

22. Tests of Controls Examples • How would you test the following controls? • All customer credit limit increases must be authorised by the credit manager. • All cash is banked on a daily basis. • A fixed asset stocktake is performed on an annual basis and the results are reconciled with the fixed assets register, to ensure that all missing/extra items and write downs are accounted for.

23. Tests of Controls Examples • How would you test the following controls? • All customer credit limit increases must be authorised by the credit manager. How would you test the following controls? • Look for credit manager’s signature on documents that authorise increases in credit limits. • All cash is banked on a daily basis • Look for daily deposits in the bank statement.

24. Tests of Controls Example • A fixed asset stocktake is performed on an annual basis and the results are reconciled with the fixed assets register, to ensure that all missing/extra items and write downs are accounted for • Either observe the stocktake or view the reconciliation documents.

25. Internal Controls and Audit Assertions Example • If the warehouse is always locked (an internal control) it is less likely that the inventory will be stolen. • This can be tested by periodically checking the warehouse door. • If the control works there will need to be less substantive testing directed at existence of inventory.

26. Internal Controls and Audit Assertions Example • If sales invoices are prenumbered then there is less chance of sales invoices going missing. • This control can be tested by sequence testing. • If the control works the will need to be less substantive testing directed at completeness of sales

27. Internal Controls and Audit Assertions Example • If all entries to the payroll journal are initiated by a timesheet that is signed by the employee’s supervisor then there is less chance that entries will be made for work that was not done. • This can be tested by checking that there is a signed timesheet for each entry in the journal. • If this control works, there is less need to test occurrence of wages expense.

28. Internal Controls and Audit Assertions Example • How would you test the following controls? Which audit assertions are affected by the following internal controls?