Solutions manual

to accompany

Auditing: a practical
approach
rd
3 edition
by

coroney, Campbell and Hamilton

Prepared by
Jane Hamilton

© John Wiley & Sons Australia, Ltd 2017

Solutions manual to accompany Auditing: a practical approach 3e

Chapter 9: Execution of the audit - performing substantive

procedures

Review questions

9.11 Explain the purpose of substantive testing and give examples of the main
types of substantive tests.

The purpose of substantive procedures is to obtain direct evidence as to the

completeness, accuracy and validity of data, and the reasonableness of the estimates
and other information contained in the financial report. That is, they are direct tests of
the amounts reported by the client in the financial statements and the relevant
disclosures.

The main types of substantive procedures are: inspection (of documents and physical
assets), observation (of client employees performing their duties), enquiry (of client
employees and directors, client solicitors and other third parties), confirmation (of
account balances with debtors, creditors and banks), recalculation (of discounts,
depreciation expense etc.), re-performance (of bank reconciliations, stock-takes etc.),
and analytical reviews (of account data at interim or year-end, comparisons with other
periods and entities etc.). Substantive procedures that are not analytical procedures are
also known as tests of detail.

9.12 Why would an auditor use observation to gather evidence? What are the
strengths and weaknesses of this type of test?

Observation is a type of test that involves observing the client personnel performing a
task. For example, the auditor could be gathering evidence about the existence of
inventory. The auditor could include observing client personnel performing the
regular stocktake.

A strength of the test is that the auditor would gather evidence on how the stocktake is
conducted, rather than rely on descriptions of the procedures from client personnel or
the client’s procedure manual which explains how to conduct the stocktake.

A weakness of the test if that client personnel may perform the procedures more
thoroughly if they are aware they are being observed, than they would normally
perform the stock take. Another weakness is that the observation provides evidence
about part of the procedure only. It would have to be supplemented by other tests that
focus on recalculation of balances, vouching of purchases back to invoices, tracing
details of the stocktake to the inventory ledger account, inspection of contracts to
determine ownership of goods in transit etc.

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9.13 What are analytical procedures? Describe how they can be used as
substantive tests in an audit.

Analytical procedures include data comparisons, ratio analysis, trend analysis,

preparation of common-size statements, break-even analysis, and pattern analysis and
regression analysis.

Analytical procedures can be used as primary tests of a balance, as corroborative tests

in combination with other procedures, or to provide at least some minimal level of
support for the auditor’s conclusion.

For example, analytical procedures would be a primary test of the balance of the
provision for doubtful debts. It would be based on analysis of accounts receivable
transactions balances for the current period and comparison with past history for this
client. Preparation of common-size statements, ratio and trend analysis would be
useful to corroborate other evidence about cost of goods sold and other expenses.

9.14 What does ‘nature’ mean in the context of the nature, timing and extent of
substantive testing?

‘Nature’ means the type of test used. There are different types of tests and the auditor
chooses the type of test based on the risk assessment for the account being tested, and
the assertion relating to that account. For example, if the auditor is gathering evidence
about the completeness of accounting payable, the auditor will use a test that is
designed to provide evidence about the liabilities that may have been omitted by the
client. Such as test could be search of payments made after the balance date to
determine if there are any accounts being paid that were not included in accounts
payable at balance date, which should have been included. If the auditor is interested
in the rights and obligations of property, then the auditor will use tests such as
inspection of title deeds to gather evidence about the legal owner of the assets. The
nature of the test is varied according to the type of account and the assertion in
question.

9.15 Explain how decisions about when and how much substantive testing is
performed relate to the overall risk assessment for the item being tested.

The nature, timing and extent of audit procedures is determined in response to the risk
assessment for the item being tested. The risk assessment includes the auditor’s
consideration of inherent risk, control risk, which together are used to determine the
level of acceptable detection risk. These assessments are conducted at the assertion
level.

If inherent and control risk are assessed as being high, acceptable detection risk is
lower. Detection risk is related to the amount of substantive testing required because a
lower detection risk requires more substantive testing, all other things being equal.
The nature of a substantive test could affect decisions about when and how much
substantive testing is performed because some substantive tests are more appropriate
for year-end testing rather than interim testing (and vice-versa). For example,

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verifying the calculation of the split between the amount to be recognised as a

prepayment and the amount to be expensed in the income statement is easiest to
perform at or after year-end. Also, some tests are easier to conduct over large numbers
of items than other tests. For example, verifying the correct authorisation for certain
transactions could require inspection of the documents, which is more difficult to do
for a large number of transactions than recalculating the discount offered to certain
types of customers which can be verified by using software to recalculate the
discounts for computerised transactions.

9.16 Explain roll-forward procedures. When are they appropriate?

Roll-forward procedures are defined as procedures that are performed during the
period between an interim date and year-end (the roll-forward period) to provide
sufficient and appropriate audit evidence to base conclusions upon as at year-end
when substantive procedures are performed at an interim date. The procedures are
used to update the auditor’s findings from the time of the interim date to the year-end.
Whether roll-forward procedures are appropriate depends on the auditor’s risk
assessment. For example, when the entity’s control environment has been assessed as
effective, controls have been tested, and no significant changes in the control
environment and controls have occurred, limited roll-forward procedures such as
analytical procedures or limited testing of intervening transactions may be all that is
necessary.

9.17 Which accounts and/or clients are more suitable for interim substantive
testing?

The timing of substantive procedures is directly influenced by the level of control

risk. The greater the assurance gained from control testing or the more effective
controls are judged to be, the more likely that substantive testing can be done at an
interim period. Therefore, clients with stronger internal controls, and accounts with
stronger controls, are more suitable for interim substantive testing.

Also, for clients or accounts where there is low inherent risk or low materiality,
substantive testing can be conducted at interim periods.

In addition, the accounts that accumulate transactions which mostly remain in the
account balance at year-end are more suitable for interim testing. For example, the
auditor can test additions and disposals to the fixed asset register prior to the year-end.
Clients with specific reporting requirements can also be suitable for interim testing. If
the client needs to close its book promptly, interim testing is a great advantage.

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 Chapter 9: Execution of the audit – performing substantive procedures

9.18 Why is it important to consider the quality of the data used in analytical
procedures? How important to this question are client controls over
financial data?

The results of analytical procedures are only as good as the data used in the
procedures. Therefore, client data that has not been audited is less reliable than
audited data, and less faith can be placed on the results of analysis using unaudited
data. Client data can also be unreliable if the client has restructured its operations or
reporting lines. The more geographical or segment diversity within the client, the less
useful aggregated data (rather than geographical or segment data) will be. Client
controls over data, including budget data, affect the quality of the data, and its
usefulness in analytical procedures.

Also, industry data that is used for comparisons can be of variable quality. Industry
data could be outdated if the industry is subject to rapid changes, such as economic
growth or decline. The industry could be less comparable with the client due to
changes in conditions or differences between the client and the average industry
member.

9.19 Vouching transactions and balances back to supporting documentation

would ordinarily provide evidence about which assertions? Which
assertions would vouching be least likely to provide evidence about?

Vouching a transaction or balance back to supporting documentation primarily gives

evidence about existence or occurrence. This is because the documentation is used to
verify that the transaction was real and valid. Vouching involves testing and verifying
information already recorded in the accounting records and is used to ensure the
balances or transactions are not overstated.

In addition, vouching can provide evidence about valuation and allocation and
accuracy. The documentation confirms the amount recorded in the accounts. Vouching
can also provide evidence about rights and obligations because the documents will
show the parties to the transaction.

Vouching does not provide evidence about completeness. This is because the auditor
is testing information already recorded in the accounting records, and as such, will not
normally uncover evidence about transactions and balances that are not in the
accounting records.

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9.20 Explain the two main types of CAATs. What are the advantages of using
software to interrogate and examine client data files? Does using CAATs
remove the need to test client control systems?

Computer aided audit techniques = CAATs

The two main types of CAATs are: (1) software used to interrogate and examine client
data files when the client is automated, (2) software to plan, perform, and evaluate
audit procedures, regardless of whether the client is automated or not.
Audit software can be used to perform procedures such as calculations and logic tests,
select and print key items and representative samples for testing. The software makes
the audit more comprehensive and efficient because the computer can handle large
volumes of data.

CAATs do not remove the need to test client control systems. Client data files are
likely to be more useful for audit testing if controls are strong, because the records
will be more complete and reliable.

9.21 What conditions must be satisfied before we can regard evidence from
analytical procedures as persuasive rather than corroborative or
minimal? Why are these conditions important?

If the auditor is using the analytical procedure to provide primary evidence, controls
over financial and non-financial data need to be more reliable. If the auditor is using
analytical procedures to provide a general understanding of the client, data quality is
not so important. However, if the procedures are designed to provide persuasive
evidence, the underlying data should be tested. For example, if the debtor’s ageing
report is being used to test the reasonableness of the provision for doubtful debts, the
report should be tested for accuracy.

Another consideration for the auditor is that the analytical procedure could rely on
non-financial data, such as quantities of raw materials, numbers of employees or
customers etc. This data is usually not subject to the same controls by the client as the
financial data, making it less reliable in analytical procedures. Where the client uses
the data for management purposes, the data is likely to be more reliable.

Analytical procedures provide more persuasive evidence when they are able to
generate an amount that the auditor believes is a reasonable estimate of what the
balance should be, allowing a conclusion about whether it is free from material error.
In this case, no further evidence is required.

Analytical procedures provide corroborative evidence if it (1) confirms findings from

other procedures, and (2) supports management representations or otherwise
decreases the level of audit scepticism. These results limit the amount of evidence
required from other procedures.

If the auditor is using the analytical procedures for minimal assurance (i.e. not
persuasive or corroborative), the auditor does not need to test the underlying data.

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 Chapter 9: Execution of the audit – performing substantive procedures

9.22 Provide an example of (1) an error and (2) a judgemental misstatement

that could affect the balance of property, plant and equipment?

Examples of errors include:

 an addition posted to the repairs expense account instead of the PPE asset
account (and vice-versa)
 a transaction posted with the wrong date around year-end
 failure to record theft of items of equipment
 failure to remove scrapped items from asset register.

Examples of judgemental misstatements include:

 inappropriate depreciation rates
 judgements around capitalisation of installation expenses and borrowing costs
 judgement of impairment/revaluation amounts.

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Professional application questions

9.23 Designing substantive procedures

Jenny has been asked to join the team responsible for designing the audit
program for a new client, Sangekar Industries Ltd (Sangekar), a
manufacturing and wholesaling firm. Sangekar recently went ‘public’ and
is now listed on the Australian Securities Exchange. Jenny has worked for
the audit firm for a year and received a very high performance rating
from her supervisors on last year’s audit of Haddin Pty Ltd (Haddin), a
firm that provides marketing and other consulting services. Sangekar and
Haddin have total revenue of approximately the same amount, so Jenny
feels confident that she can apply her knowledge to the new audit. She
takes a copy of the audit program for Haddin along to the first meeting,
intending to suggest they use it as the basis for the audit program for
Sangekar. Jenny thinks that the Sangekar audit program could use the
same substantive procedures they used on the Haddin audit.

Required
List some of the problems with Jenny’s idea of using Haddin’s audit
program as a basis for designing substantive procedures for Sangekar.

Sangekar and Haddin have approximately the same amount of revenue, but there are
substantial differences between the firms. Sangekar is a recently publicly listed
manufacturing and wholesaling company. Haddin is a firm that provides marketing
and other consulting services, listing status unknown.

The auditing standards require the auditor to gain an understanding of the client and
its circumstances. For example, the auditor should gain an understanding of the
operating conditions in the client’s industry as well as the economy generally, and the
reporting requirements that apply to the firm (which would be influenced by its listing
status). The auditing standards require audit plans to be based on the auditor’s
assessments of inherent and control risks at the client, and the nature, timing and
extent of substantive procedures should reflect these risk assessments.

Therefore, the main problems with using Haddin’s audit program as a basis for
designing substantive procedures for Sangekar relate to the fact that by doing so the
auditor may not properly work through the effects of Sangekar’s circumstances on the
audit program.

Examples of specific problems:

 The auditor may use the wrong type of substantive procedures, e.g. not
incorporate tests of inventory balances (which would not be on Haddin’s
balance sheet) and accounts receivable balances.
 The auditor may not make a thorough assessment of internal controls at
Sangekar and therefore not schedule control tests in time to use the results of
the control tests to determine the nature, timing or extent of substantive
procedures.
 The auditor may not schedule tests of disclosures required by listed firms that
are not required for Haddin.

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9.24 Sales cut-off

Boris Johnson suggests the following audit procedure should be included

in the audit program to gather evidence on the cut-off assertion for the
revenue account:

Select a sample of sales from the sales journal and agree the dates on the
invoices to the dates on the delivery documents signed by the customer.

Required
Explain how the procedure addresses the assertion. What does it mean if
(i) the dates agree, or (ii) the dates do not agree?

Selecting a sample from the sales journal from around the year-end to agree the dates
on the invoices to the dates on the delivery documents which are signed by the
customers gathers evidence that the date the transaction is recorded in the accounting
records is the same as the date the goods are delivered to the customer, and thus the
sale is complete. The dates on the sales invoice and the delivery document should be
the same as the date the sale is processed by the audit client, unless there are
arrangements to deliver goods at a later date after the sale (need evidence that the
customer was responsible for payment despite delivery not being finalised), or earlier
(if the goods were delivered on approval).

This test would be most effective if dates in the sales journal on both sides of the year-
end are selected in the sample. This is because selecting dates prior to the year-end
provides evidence that sales are not brought forward from post-balance date to dates
prior to balance date, and selecting dates after the year-end provides evidence that
sales are not held over from dates prior to balance date to post-balance date.
If the dates on the delivery document, sales invoice, and sales journal are not the
same, it is an error unless there is evidence to support a different effective date for the
sale (i.e. check the contract terms for sale on approval etc. as discussed above.).

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9.25 Sales journal and invoices

Boris Johnson has another suggestion for the audit program for the
revenue account. This time he suggests:

Select a sample of sales from the sales journal and agree the details in the
journal to the sales invoices, delivery dockets and customer orders.

Required
Explain which assertion for the revenue account would be addressed by
this test.

Selecting a sample of sales from the sales journal and agreeing the details in the
accounting records with the original documents (invoices, delivery dockets and
customer orders) provides evidence for the occurrence assertion for sales. The
documents show whether the transaction, as recorded, did occur.

Agreeing the details with the underlying documents (known as vouching), also
provides evidence about accuracy of sales.

This test gathers more evidence about the transaction that just the date of the sale (as
in the previous question).

9.26 Sales invoices and journal

Seb Coe and Boris Johnson are discussing the audit program for the
revenue account. Seb and Boris disagree about whether they should use
procedure A or B below to test the occurrence assertion for the revenue
account:

A. Select a sample of sales from the sales journal and agree the details in
the journal to the sales invoices, delivery dockets and customer orders.
B. Select a sample of sales invoices, delivery dockets and customer orders
and agree the details to the details recorded in the sales journal.

Required
Which test provides evidence about the occurrence assertion? Why?
Which assertion does the other test provide evidence about?

The occurrence assertion is tested by selecting a sample of items in the accounting

records and agreeing the details to the underlying documents. The test answers the
question: Did this item shown in the accounts actually occur? This is because the test
gathers evidence from the documents about the item in the accounts.
Test A addresses the occurrence assertion.

The completeness assertion is tested by selecting a sample of documents and agreeing

the details to the accounting records. The test answers the question: Are the
accounting records complete? That is, do they include this transaction? This is
because the test gathers evidence about the completeness of the accounting records by

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testing if the transactions in the documents were entered into the accounting records
correctly.

Test B addresses the completeness assertion.

9.27 Payroll testing

Peter has the task of designing the audit program for the payroll area.
There have been no recent changes to the payroll system, or its interface
with the general ledger. Among other tests, Peter is considering using the
following analytical procedures to gather evidence:

1. Compare payroll tax expenses to the annual payroll times the statutory
tax rates.
2. Compare the relationship between direct labour costs and number of
employees with prior periods.

Required
(a) Discuss the type of evidence which would be obtained from each of the
procedures.
(b) Would your answer be any different if there had been recent changes
to the payroll system? Explain.

(a)

1. Compare payroll tax expenses to the annual payroll times the statutory tax rates.

Payroll tax is levied by the government at a prescribed rate of tax on the total amount
of payroll. If the amount of payroll is known, and the tax rate is known, the amount of
payroll tax can be calculated.

Recalculation involves checking the client’s calculations for accuracy, and would be
persuasive evidence.

2. Compare the relationship between direct labour costs and number of employees
with prior periods.

Direct labour costs (salary payments, superannuation levies etc.) have a relationship to
the number of employees where an increase in the number of employees results in an
increase in direct labour costs. Because each employee could be on a different rate of
pay, the amount of costs cannot be obtained simply by multiplying the number of
employees by a constant number. However, the test would determine if there was a
significant difference in the relationship between employee numbers and direct labour
costs which should be investigated further. As such, the evidence would not be
conclusive but supportive of other tests.

(b) Recent changes to the payroll system could change the relationships between
various items, which would impact on the usefulness of the analytical procedures. For
example, if a group of employees was treated differently in the payroll system after
the change, the number of employees as a proportion of the direct labour costs would

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vary. For example, casual employees are included in the main payroll system
alongside permanent employees, whereas previously their pay and details were
handled in a different system. The number of employees as a ratio of direct labour
costs would be different for casual employees than for permanent employees because
the casuals’ weekly pay would be lower than the permanent employees (assuming
they worked only a limited number of hours per week).

9.28 Selecting debtors for substantive testing

A theme park business has a website that allows customers to make

bookings online. The customers include the general public and local and
international travel agents. Travel agents that wish to be able to make
bookings on credit must complete an account application form with at
least three references. The auditor’s tests provide sufficient appropriate
audit evidence that credit is granted only after rigorous credit checks.
However, large travel agents often settle their accounts between 60 and 90
days (not the required 30 days). Given the amount of business generated
from these travel agents, the theme park business allows this practice to
continue. The business has 720 travel agents as customers. Forty agents
represent 65 per cent of trade debtors.

Required
(a) Discuss which debtors would be selected for further testing.
(b) When would the testing of debtors be carried out?

The key assertions at risk for debtors are existence (do the debtors really exist?) and
valuation (are the debtors valued appropriately?). The auditor is concerned about the
risk of overstatement. This means that the larger debtors would be of most concern.
The testing has revealed that rigorous credit checks are conducted before debtors are
able to purchase from the client on credit, providing some assurance that the debts are
collectible. However, the constant late payments increase the risk that accounts will
not be paid, either because of financial deterioration of the debtor or a dispute
between the client and the debtor about a particular sale.

Forty debtors represent 65% of the debtors. A sample of the forty debtors should be
selected. An additional sample of other late-paying travel agents should also be
selected. A small sample of the remaining debtors should also be selected.

There are strong controls over credit approval. If other controls over debtors and sales
are also strong, the testing for existence could be carried out prior to the year end with
roll-forward procedures. Testing for valuation should be carried out closer to the year-
end as evidence of deteriorating financial position of debtors would be more likely to
be gathered closer to year-end. Testing of subsequent receipts from debtors (post
balance date) would provide strong evidence to support debtor valuation at year-end.

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9.29 Data for analytical procedures

Reliable Paper Ltd provides cardboard, paper and plastic packaging

materials to a large number of manufacturers and distributors in all
states. The cardboard and paper division is a well-established business,
but Reliable Paper Ltd has been providing plastic products only since its
takeover of Plastic Products Ltd 18 months ago. The takeover doubled
Reliable Paper’s revenue and caused changes in its management structure
— adding another two divisional managers. These new divisional
managers are in charge of plastic product sales to different areas of the
country — Plastic Eastern and Plastic Western — and they join the Paper
Eastern and Paper Western division managers in reporting directly to the
CEO.

All internal operating reports are now structured along the four divisional
reporting lines, although external financial reports continue to be
produced for the whole business. All purchasing and billing systems are
fully integrated, although it is possible to extract data along divisional
lines, and by state (as before). Reliable Paper purchases bulk supplies of
raw plastic and paper and makes boxes, rolls and sheets of these materials
to fill customer orders. Production processes in the paper divisions have
not changed, and Reliable Paper has made minimal changes to the
production processes used by Plastic Products Ltd.

Required
List and discuss the factors that would increase or decrease the reliability
of data used in analytical procedures at Reliable Paper Ltd.

Factors increasing reliability of data include:

 Data used for management purposes, suggests that management have faith in
its reliability.
 Data is generated by state and division, allowing new business segments to be
removed before comparison with prior years.
 Well-established business, suggesting good business practices and reliable data
being used.
 Purchasing and billing systems are fully integrated, suggesting data is used
consistently through the business.
 Few changes to production processes in paper business.
 cinimal changes to new plastics business since acquisition, allowing analysis
of this division with data held for prior years (if available).
 Takeover was 18 months ago, suggesting that this year would be a full year of
data.

Factors decreasing reliability of data include:

 Acquisition of new plastics business makes whole of business reports not
comparable with previous years.
 Any changes such as growth could distort comparisons.
 Could be increased pressures for growth and/or profitability, changing the
incentives for accurate reporting (i.e. managers could have incentives to
manipulate figures for their division).

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 Last year’s data was difficult to analyse because of acquisition half-way

through the year, making last year’s data not as useful for comparisons.

9.30 Persuasiveness of evidence from analytical procedures

Brian has the task of reviewing the evidence from analytical procedures
conducted by the audit assistants on the audit of Smalley Services Ltd.
The audit assistants have reported the results of these analytical
procedures:
1. Comparison of depreciation expense with the closing balance of each
depreciable asset class in property, plant and equipment.
2. Recalculation of sales commission expenses using the standard sales
commission rate and total sales.
3. Comparison of payroll expense with previous year payroll.

Required
(a) What questions would Brian ask about each analytical procedure?
(b) If all questions could be answered satisfactorily, explain whether the
evidence from each analytical procedure would be persuasive,
corroborative, minimal or general. What are the implications of this
judgement for further substantive testing?

(a) Questions Brian could ask include:

(1)
 What acquisitions and disposals have occurred for each depreciable asset
class? (These would affect the balance of assets at the end of the period
although depreciation expense is for all assets held during the period.)
 Are the same rates used for each asset in the asset class?
 Have the closing balances for the assets been verified? Are there any other
changes in the business suggesting that asset balances should be different?
 Are there any significant changes from last year?

(2)
 Are sales commissions ever given at non-standard rates? If so, to which
salespeople or for which products? Are all sales subject to sales commission?
 Has total sales been verified?
 Are there any significant changes from last year?

(3)
What changes in personnel numbers have there been this year (i.e. new employees or
employees leaving?)
Are there any changes in pay rates for some employees?
Are there any other changes in the business suggesting that employee numbers or
payroll expense should be different?
Are there any significant changes from last year?

(b) In all cases, the results of the analytical procedures would be more persuasive if
the underlying data has been audited and is consistent with other evidence obtained

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during the audit. Also, in all cases there are reasons to expect the relationship between
the data to be consistent if the relevant conditions are similar to those in previous
years. The most persuasive tests would be (1) and (2) because they involve more than
a mere comparison with the previous year. However, both these tests could be
improved. For example, test (1) would require an adjustment for disposals and
acquisitions to improve its persuasiveness, and test (2) would be more persuasive if
data about product lines and relevant sales commissions were available. Test (3)
would be more persuasive if the total payroll expense was calculated on an employee
basis before comparing with the previous year. If the test is more persuasive, less
further substantive testing would be required. For each of these tests, it is likely that
no further testing would be required if all questions are answered satisfactorily and
improved as suggested above.

9.31 Tests of details

Marty has to audit the sales transactions of Okawa Ltd. Okawa Ltd
supplies tools to the mining industry and carries a large number of
different makes and models of standard mining tools. Okawa Ltd also
designs and manufactures tools for special purposes and for miners
operating in difficult conditions. The custom designed tools are made only
on the signing of a contract and receipt of a deposit, whereas standard
tools are supplied to regular customers on receipt of a telephone order.
Okawa Ltd’s sales transactions vary from a few dollars to millions of
dollars depending on the number of items sold and whether the individual
items are large or small tools, and whether the tools are standard items or
custom designed.

Marty is instructed to gather evidence about the sales transactions using

sampling and vouching. This is explained in detail in the audit program.

Required
(a) What would you expect to see in the audit program given to Marty
about (1) the sample selection and (2) the vouching procedures? Explain.
(b) How could Marty use CAATs to help gather the evidence?

(a) The major risk is overstatement of sales. Therefore, we would expect to see
substantive procedures in the audit program designed to test the assertions of
occurrence and cut-off for sales. This focus drives the sample selection. The audit
program would require sampling of recorded sales transactions. Key items would be
selected on the basis of size (there are some very large transactions) and date (because
those sales recorded as occurring just prior to the year-end are potentially misstated
sales that occurred just after the year-end). Depending on the auditor’s assessment of
the strength of controls over custom tools and standard tool sales, the sample could
sample relatively more of one type of sale transaction. Key item selection and testing
would allow the auditor to gain reasonable assurance that the total sales balance was
adequately ‘covered’, although the auditor might also require testing of a
representative sample of the remaining items.

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The vouching procedures would require carty to inspect documents supporting the
sales transactions. carty would be instructed to start with the items selected as above,
and locate the relevant documentation (sales order or contract, shipping documents,
sales invoice). carty would be instructed to verify the date and amount of the sales
transaction, plus the details of the items sold. He would be instructed to recalculate
the total price by reference to number of units and the agreed price. In the case of
custom designed tools, carty would be able to inspect a contract and obtain the
details of price from it, but in the case of standard tools carty would need to obtain
the record of the telephoned sales order and use standard price lists. The number of
items shipped to the customer would be verified by inspecting the shipping documents
that are reconciled by the client to the sales order and copy of the invoice.

(b) CAATs would be useful to carty (and others in the audit team) in:
 calculating the size of the samples
 selecting items from the population to include in the sample
 searching for electronic records of sales documents
 recalculating # unit x unit price
 analysing fluctuations in recorded sales to search for unusual patterns (e.g.
by time, customer, product)
 interpreting the results of the tests
 writing working papers recording the results of the tests.

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 Chapter 9: Execution of the audit – performing substantive procedures

9.32 Evaluating substantive testing results

The following items are documented in the audit working papers.

1. Sales transaction included in the year ended June 2017 but evidence
from the cut-off procedure suggests that the sale should be dated 1 July
2017 ($550 000).
2. Warranty expenses in the trial balance for the year to June 2017 total
$150 000; the provision for warranty claims as at 30 June 2016 was $100
000. Evaluation of correspondence suggests that an additional $200 000 in
warranty claims could result from ongoing disputes with customers. No
provision for these claims has been made. Management has made a
warranty provision for 2017 of $120 000.
3. Redundancy expenses related to reorganisation of head office
administration incorrectly charged to rental expenses ($927 440).
4. No expense for impairment of assets has been made by management. A
drought-induced recession has adversely affected property values in
regional cities where seven branch offices are located (head office and two
branch offices are located in the capital city). Total land and buildings in
the trial balance is $20 000 000 and management estimate that the value
of these assets is impaired by 10 per cent.

Required
(a) Evaluate each item above and explain whether it is an error or a
judgemental misstatement. What action do you recommend for each?
(b) Which accounts would be affected, and how, if an adjustment is made
for each item?

(a) and (b)

(1) Error - because the sale is included in the wrong accounting period (unless the date
of 1 July 2016 is based on a judgement about the nature of the sales contract). The
sale should be included in the next period. The client has incorrectly recorded the sale
on 30 June as: Dr accounts receivable, Cr sales. To correct this error, the adjusting
entry would be to reverse the entry for 30 June and record it as 1 July ($550,000).

(2) The management underestimated the provision for warranty claims for the year
ended 30 June 2016. They estimated $100,000, and (depending on how the
information in the question is interpreted) there are already an additional $150,000 in
processed claims and a further $200,000 to be processed. canagement estimate a
provision for the year ended June 2016 of $120,000. The new provision appears to be
inadequate, and is a judgemental misstatement. The entry to increase the current year
provision would be Dr Warranty expense, Cr Provision for warranty for the amount of
the increase.

(3) Error – the redundancy expenses were charged to the wrong expense account. An
adjusting entry should be made: Dr Redundancy expenses, Cr Rental Expenses
($927,440).

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Solutions manual to accompany Auditing: a practical approach 3e

(4) The amount for impairment of assets to be recognised in the accounts is a

judgement. In this case, there is evidence that the following entry should be made: Dr
Impairment expense Cr Asset, for 10 per cent of $20 000 000: $2 000 000.

9.33 Timing of substantive tests

Melissa is the recently appointed engagement partner of the audit of

Brumby Ltd. Melissa has just taken over the audit from Ken Leo, who
rotated off the audit after a five-year period as the engagement partner.
Ken had a small portfolio of clients and was able to complete most
substantive testing for Brumby at year-end. Melissa is unable to do this
because she is facing difficulties with two of her other large clients. These
clients have just been advised that their financing arrangements with US-
based banks may not be renewed, raising doubts about their ability to
continue as a going concern. The US banks will make their financing
decisions very close to the clients’ year-end, forcing Melissa to spend
considerable time in this period with these clients.

The financing problems at Melissa’s existing clients have created demands

on Melissa’s audit team that she must resolve. The audit firm cannot
provide her with the additional staff she has requested for the year-end
period because several other partners’ clients are also facing financing
difficulties due to the credit crisis in the United States.

The audit firm’s ethical rules do not allow Ken to remain as the auditor of
Brumby and it is too late to find new partners for any of her other clients,
so Melissa must find a way to continue with the audit and still meet all
professional and legal standards. So far, the audit team has conducted the
preliminary risk assessment for Brumby and early control testing results
confirm that Brumby has excellent controls.

Melissa calls a meeting with her senior audit team members to discuss the
issue.

Required
Explain how Melissa could vary the timing of the substantive testing at
Brumby to help her meet her audit obligations. Specifically:
(a) give examples of substantive procedures that could be performed prior
to year-end
(b) explain how Melissa will use roll-forward procedures to complete the
audit
(c) explain any other considerations that would affect the timing of
substantive procedures for Brumby.

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 Chapter 9: Execution of the audit – performing substantive procedures

(a) Some substantive procedures could be performed at interim periods. These would
be most likely in the following accounts:
 Accounts which accumulate transactions which remain in the account
balance at year-end (e.g. verify additions to fixed assets).
 Accounts where controls are confirmed as strong (which they appear to
be), and high acceptable detection risk (tests could be done up to six
months before year-end).
 Accounts where controls are believed to be strong, and controls will be
tested (tests could be done 2 or 3 months before year-end).
 Accounts with limited materiality (e.g. small asset accounts) or low
likelihood of errors (i.e. low inherent risk).

(b) Roll forward procedures update the findings from the interim tests. For example,
analytical procedures could be used to test if the patterns of revenue or expense
transactions are similar before and after the interim tests. A sample of transactions
from after the test date could be taken and further tests of details performed.

(c) In general, risk assessments affect the timing of substantive procedures. If inherent
risk and control risk are low, allowable detection risk is high. This means that the
timing of the substantive tests is more flexible. For example, good internal controls
over inventory would allow interim stock-take testing. In addition, the nature of
substantive tests affects the timing of the tests. Some tests are more relevant at year-
end than at interim periods. E.g. the auditor would test the completeness of liabilities
at year end, but details of individual liabilities could be tested prior to year-end.

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Solutions manual to accompany Auditing: a practical approach 3e

Questions 9.34–9.37 are based on the following case.

Chan & Partners Chartered Accountants is a successful mid-tier accounting firm

with a large range of clients across Australia. During the 2017 year, Chan &
Partners gained a new client, Medical Services Holdings Group (MSHG), which
owns 100 per cent of the following entities:

 Shady Oaks Hospital, a private hospital group

 Gardens Nursing Home Pty Ltd, a private nursing home
 Total Cancer Specialists Limited (TCSL), a private oncology clinic that
specialises in the treatment of cancer.

Year-end for all MSHG entities is 30 June.

You are a senior auditor working on the Shady Oaks Hospital engagement for
the 2017 year and are currently in the planning stage of the audit. In discussions
with management you discover that Shady Oaks has recently acquired two new,
full body scanning machines. These machines use the latest technology and cost
the company more than $10 million each. Although they are more than 50 per
cent more likely to detect tumours and other abnormal internal growths, there
are new academic studies suggesting there may be potential long-term side
effects for patients scanned by these machines. However, because the machines
are new the evidence about long-term effects will not be known for many more
years. Despite this, there has been some bad press for Shady Oaks highlighting
the potential risks to patients.

Shady Oaks charges a premium price for using the scanning machine and there
is extremely high demand. To manage the demand Shady Oaks requires that all
patients pay for their scans in full at the time of booking, and the payments are
immediately recognised as revenue by the hospital. Shady Oaks has taken
bookings for four months in advance — although it is only April 2017, the
hospital has bookings for July and August 2017.

The Australian Doctors and Hospital Association is currently reviewing the use
of the scanning machines and is considering banning their use within Australia
until the issue is resolved. A decision is expected on 1 August 2017, and
management tell you that they believe there is an 80 per cent chance the scanners
will be approved.

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 Chapter 9: Execution of the audit – performing substantive procedures

9.34 Substantive testing for specific assertions at risk

(a) Identify two key account balances likely to be affected by the above
information.
(b) For each account balance identified in (a) above, identify and explain
the key assertions most at risk.
(c) For each assertion identified in (b) above, identify specific substantive
tests of detail that would be responsive to the identified risk.

(a) Key account balances: (i) Scanning revenue, (ii) Accounts receivable, (iii)
Scanning machine (fixed asset account),

(b)

(i) Occurrence - has revenue occurred? Recognising revenue at time of receipt of cash
is not consistent with revenue recognition principles (services has not been delivered).

(ii) Existence – does the asset exist because the service has not been delivered?

(iii) Valuation and allocation – what is the appropriate value for the scanning
machines given the uncertainty around their approval?

(c) Read the contracts for use of the scanning machines. Is there anything to support
the early recognition of the revenue and the claim against the patient? (e.g. the
hospital has the right to deliver an alternative service; the patient does not have the
right to a refund). Obtain a legal opinion.

Consider the documentation surrounding the regulation of the scanning machines. Is

the Australian Doctors and Hospital Association the relevant approving body? If this
body withholds approval, is the hospital still able to use the machines legally?

Talk to management. What evidence does management have to support their view that
there is an 80% chance of the scanners being approved? Obtain an independent
expert’s view of the regulatory situation.

Read the press reports. How extensive is the bad press surrounding the scanning
machines? Is it likely to affect patient demand for the services? Would all these
factors affect the value of the machines?

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9.35 Using analytical procedures

Your assurance services manager has requested you use substantive

analytical procedures to calculate Shady Oaks’ estimated revenue for
patients staying in the hospital, excluding medical procedures and
ancillary costs such as medication.

Required
Based on the background provided, describe all the key information
required to estimate Shady Oaks’ revenue for patients staying in hospital.

Number of patients treated in the hospital for this period and prior periods, with
details about patient type and length of stay.

Obtain patient data per ward during different periods during the year (different wards
could have different charges e.g. maternity vs. rehabilitation).

Calculate revenue per patient (by ward or other characteristic such as patient type) in
past, apply to this period.

Compare revenue per patient to other similar hospitals.

Use personnel and other operating data to estimate reasonableness of patient data. For
example if the number of nurses increases, it is likely that number of patients also
increases.

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 Chapter 9: Execution of the audit – performing substantive procedures

9.36 Planning substantive tests

Inventory of various medical supplies and drugs is a material account on

the Shady Oaks Hospital audit engagement. You are planning to adopt a
combined audit approach for existence of inventory and place a heavy
reliance on preventative control procedures around the physical security
of inventory, such as access to the dispensary and the store room being
limited to a few authorised staff.

You have just completed your tests of controls in relation to physical

security procedures. Your projected error rate based on the results of
your already large sample size is higher than the tolerable error. You are
satisfied that the sample is representative and the errors occurred
throughout the period audited.

Required
(a) Briefly outline the impact of the projected error rate on your planned
substantive audit procedures.
(b) Assume that all of the deviations from the internal control procedures
tested (that is, errors in the sample) relate to a three-week period when a
senior staff member was on annual leave. Discuss how this would affect
your planned substantive tests of detail.

(a) A high projected error rate suggests that the controls are not working effectively.
The required audit response is to increase the assurance gained from substantive
testing. This can be done by using more effective substantive procedures, altering the
timing of the substantive procedures to closer to year-end, and/or increasing the extent
of the substantive procedures (i.e. increasing sample size). For example, greater
reliance on tests of detail and less reliance on analytical procedures would normally
provide greater assurance.

(b) If all the control deviations can be isolated to a specific period, the increased
substantive procedures could be addressed to this period rather than applied to the
entire period. The auditor should also consider if the relevant senior person was on
leave at other periods, and increase testing during those times as well. In addition, the
auditor should consider discussing the issue with management to determine the cause
of the problems. For example, are there issues with covering the absence of other staff
members? Is there adequate training provided for staff taking on higher duties when
colleagues are absent? How does this reflect on general control environment at the
client?

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Solutions manual to accompany Auditing: a practical approach 3e

9.37 Persuasiveness of evidence

Review your answers to the previous questions. Comment on the

persuasiveness of evidence from each test. Explain any factors that would
affect your assessment.

In general, the analytical procedures would provide less persuasive evidence than the
tests of detail. However, the analytical procedures, such as estimating revenue from
patient data, would be useful as corroborative tests or general tests. In this case, the
auditor would also use tests of detail relating to patient revenue. Revenue from
patients is also likely to be very material to the audit, so more than one type of tests
would be required to provide the required level of assurance.

The tests of inventory controls showing breakdowns during a three week period
would be relied upon to restrict additional substantive testing to that period, and
therefore would need to be highly persuasive. Additional testing to provide the highest
level of assurance that the controls were effective during other periods would save the
auditor completing unnecessary additional substantive tests.

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 Chapter 9: Execution of the audit – performing substantive procedures

Case study – Cloud 9

Answer the following questions based on the information presented for Cloud 9
in the appendix to this text and the current and earlier chapters. You should also
consider your answers to the case study questions in earlier chapters.

Required
Using the results of your controls testing in the case study in chapter 8, assess the
control risk for the following assertions and write your conclusions in the
worksheet below.

Assess control risk:

An exception was found in the testing for the control surrounding matching of sales
orders to signed dispatch notes in chapter 8. Students should have concluded that the
control was not working effectively based on the information provided. In practice,
the exception would be investigated and it would be determined if this was a one-off
event or if there was a mitigating control that was in place and operating effectively.

Students may also have noted the difference in dates between the invoice date and the
dispatch date. This is because the invoice, although generated in draft when the
dispatch note is approved, is not sent until it is properly matched with the signed
dispatch note.

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Solutions manual to accompany Auditing: a practical approach 3e

Assuming no further testing was performed, based on the results the control risk for
the relevant account assertions would be assessed as follows:

Account Assertion Control Risk Explanation

Sales – Occurrence cedium The exception found in the testing provides evidence
that the sale was recorded although the dispatch note
was not signed. Without further testing, it could not be
determined that the customer received the goods,
thereby triggering the sale to be recorded.
However, the shipping supervisor authorisation also
covers the Occurrence assertion and was operating
effectively.
Sales – Completeness Low The matching of sales invoice to the dispatch note
provides evidence that the sale is recorded when goods
leave the warehouse.
Sales - Allocation Low No exceptions were noted in the matching of quantity
between the invoice and dispatch note.
A/R – Existence cedium The effects of the sales exception are offset by the
successful cash receipts testing. By confirming through
testing that the cash is properly posted to the A/R
balance, this provides evidence that the customer
balance did exist (i.e. they are paid the balance).
A/R – Completeness Low The reconciliation testing provides comfort that all cash
received is posted to the accounts receivable balance.
A/R - Valuation Low No exceptions were noted in the matching of quantity
between the invoice and dispatch note.
Cash – Existence Low By matching the cash receipt journal (through the A/R
batch) to the bank statement, the existence of the cash
balances is confirmed.
Cash – Completeness Low Testing shows that cash received in bank is recorded in
the general ledger.

The control risk represents the auditors’ assessment of the likelihood that Cloud 9’s
internal control procedures would not prevent or detect a material misstatement.

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 Chapter 9: Execution of the audit – performing substantive procedures

Research question

Economic conditions and financial markets were significantly affected by the

global financial crisis (GFC) in 2008. The GFC had an impact on many
businesses in many countries and was one of the largest economic recessions in
recent years. Although the GFC’s effects may have passed, the risk of smaller
economic recessions affecting specific industries remains part of life. Love and
Lawson identified a series of specific issues flowing from the GFC that must be
considered by financial statement auditors and may affect the procedures used in
conducting an audit during economic recessions.

Required
Explain the possible impact of economic recessions on decisions about the nature,
timing and extent of substantive testing. Give specific examples of the impact on
analytical procedures, and how auditors would adjust their audit programs to
ensure overall audit risk remains acceptable.

© John Wiley & Sons Australia, Ltd 2017 9.27