7.

Intro to Substantive Procedures Page 59

Ch # 7: Introduction to Substantive Procedures

The financial statement Assertions (ISA 315)

Assertions
Representations by management, explicit or otherwise, that are embodied in the F/S, as used by the
auditor to consider the different types of potential misstatements that may occur.

Assertions about classes of transactions and events and related disclosures:

❑ Occurrence: Transactions and events that have been recorded or disclosed have occurred and relate
to the entity.
❑ Completeness: There are no unrecorded transactions, events and disclosures.
❑ Accuracy: Amounts and other data relating to recorded transactions and events have been recorded
appropriately and related disclosures have been appropriately measured.
❑ Cut-off: Transactions and events have been recorded in the correct accounting period.
❑ Classification: Transactions and events have been recorded in the proper accounts.
❑ Presentation: Transactions and events are appropriately aggregated or disaggregated and clearly
described and related disclosures are relevant and understandable.

Assertions about account balances and related disclosures:

❑ Existence: Assets, liabilities and equity interests exist.

❑ Rights and obligations: The entity holds or controls the rights to assets, and liabilities are those of
the entity.
❑ Completeness: There are no unrecorded assets, liabilities or equity interests and all related
disclosures have been included.
❑ Accuracy, valuation and allocation: Assets, liabilities and equity interests are included in the F/S at
appropriate amounts and any resulting valuation or allocation adjustments are appropriately
recorded and related disclosures have been appropriately measured and described.
❑ Classification & Presentation: Assets, liabilities and equity interests are appropriately aggregated
or disaggregated and clearly described, and related disclosures are relevant and understandable.

TUTOR’S NOTE
This area (Assertions) have been classified in ICAP Study Text under Chapter # 3. But we would be
discussing the topic here for developing a comprehensive understanding, linking and for developing the
substantive procedures using the assertions using the pattern given on the next page.
7. Intro to Substantive Procedures Page 60

TUTOR’S NOTE – HOW TO DRAFT AUDIT PROCEDURES USING ASSERTIONS

Assertions Class of Account Typical Audit Procedures

Transaction Balance
1) : Are / Were these Present ?
▪ Inspection of supporting documentation
Occurrence  
▪ Inspection of items purchased
▪ Physical verification
Existence  
▪ Third party confirmations
2) : Recorded at correct Amounts ?
▪ Recalculation of amounts
Accuracy   ▪ Third party confirmation
▪ Analytical review
▪ Matching amounts to invoices
Accuracy,
▪ Recalculation
Valuation and  
▪ Review of post year-end payments and invoices
Allocation
▪ Expert valuation
3) : Are all Recorded ?
▪ Review of post year-end items
▪ Cut-off testing
Completenes   ▪ Analytical review
▪ Confirmations
▪ Reconciliations to control accounts
4) : Should it be included at all ?
▪ Reviewing invoices for proof that item belongs to
Rights &
  company
Obligation
▪ Confirmations with 3rd parties
▪ Cut-off testing
Cut-Off  
▪ Analytical review
5) : Properly disclosed and presented?
▪ Confirming compliance with law and AFRF
Classification   ▪ Check the recording in proper account
▪ Reviewing notes for understandability
Presentation   ▪ Confirming accounting policy is consistent.
7. Intro to Substantive Procedures Page 61

The role of substantive procedures

Students are advised to have a quick recap of the following concepts from Ch # 4

Financial Statements Assertions

Classes of transactions and events: Account balances:
Tutor ▪ Occurrence ▪ Existence
Note ▪ Completeness ▪ Rights and obligations
▪ Accuracy ▪ Completeness
▪ Cut-off ▪ Accuracy, valuation & allocation
▪ Classification ▪ Classification
▪ Presentation ▪ Presentation

Methods of obtaining audit evidence for substantive testing

▪ Inspection
▪ Observation
▪ Inquiry
▪ Re-calculation
▪ Re-performance
▪ External Confirmation
▪ Analytical procedures

Analytical Procedures (ISA 520)

Analytical procedures must be used:

▪ At the audit planning stage, in order to:
- Gain a better understanding of the client entity and its business, and
- Help identify areas of high audit risk
▪ As a substantive procedure during the audit to look for possible material misstatements
▪ At the end of the audit, in the overall review of the audit, to assist the auditor when forming an overall
conclusion as to whether F/S are consistent with his understanding.

The nature of analytical procedures

“Analytical procedures” are defined as “evaluations of financial information through analysis of plausible
relationships among both financial and non-financial data”.

▪ Much of the analysis consists of measuring ratios, and comparing ratios of current year’s financial
results with expected ratios, and ratios from previous periods.
▪ If a ratio seems unusually high or low, this might indicate that one of the two figures used to calculate
the ratio is either abnormally high or abnormally low.
▪ If key ratios are close to what they are expected to be, auditor may take this as evidence that the
relevant balances or transaction amounts are reliable and ‘accurate’.
▪ If a ratio is very different from what is expected, the auditor should investigate the reason for the
variation.
- There may be a good reason for it; or
- There may be a misstatement in the F/S.
7. Intro to Substantive Procedures Page 62

Comparisons
Comparisons can be made with
▪ Prior accounting periods
- To establish patterns and trends
- To look for unusual fluctuations
▪ Expected results
- Budgeted results or with forecasts, or with auditor’s expectation.
▪ Industry average results
- Industry as a whole; or
- Individual entities in the same industry (may be obtained through published F/S).
▪ Comparable parts of the same entity
- Different branches or divisions within the same entity

Limitations of Ratio Analysis

▪ Its usefulness depends on the quality of the underlying financial information.
▪ For comparison purposes, the information must be calculated on a consistent basis.
▪ The two figures used to calculate a ratio must be logically related.
▪ The auditor needs to understand the client’s business properly to interpret ratios.

Analytical procedures in substantive testing

When designing and performing substantive analytical procedures, the auditor shall:
▪ Determine suitability of particular substantive analytical procedures for given assertions
- Analytical procedures are more appropriate when relationships are predictable
▪ Develop an expectation of recorded amounts or ratios
▪ Evaluate whether that expectation is sufficiently precise to identify a misstatement:
- Accuracy with which amounts can be predicted;
- Extent to which information can be disaggregated (i.e. further divided); and
- Availability of information.
▪ Evaluate the reliability of the data from which the expectation has been developed:
- Source of the information;
- Comparability of the information available;
- Nature and relevance of the information available; and
- Controls over the preparation of the data.
▪ Determine what level of difference from expected amounts is acceptable without further investigation

The auditor will normally use analytical procedures to obtain supplementary audit evidence
▪ Analytical procedures are generally designed to provide evidence that supports or corroborates (or
possibly contradicts) outcome of other testing procedures
▪ It is not appropriate to base the audit conclusion on analytical procedures alone.
▪ However it may provide sufficient appropriate audit evidence for a particular assertion if:
- Assessed risk of material misstatement is low; and
- Outcome is sufficiently accurately predictable through the use of substantive analytical procedures
alone.
Investigation of fluctuations and relationships

If the auditor finds unacceptable fluctuations or differences he shall:

▪ Make enquiries of management and verify management’s responses, and
▪ Responses should be confirmed by further audit work
▪ Perform other audit procedures as necessary
▪ Use other audit evidence to help explain their unexpected and unusual value.
7. Intro to Substantive Procedures Page 63

Common ratios

Profitability ROCE =
Profit before interest and taxation
 100%
ratios Share capital and reserves + Long - term debt capital

Profit
Profit/sales ratio =  100%
Sales

Sales
Asset turnover ratio =
Share capital and reserves + Long - term debt capital

Working Trade receivable s

Average days to collect =  365 days
capital Sales
efficiency
ratios Inventory
Inventory turnover =  365 days
Cost of sales

Trade payables
Average time to pay =  365 days
Cost of purchases

Liquidity Current ratio =

Current assets
ratios Current liabilities

Current assets excluding inventory

Quick ratio =
Current liabilitie s

Debt Ratios Long - term debt

Gearing =  100%
Share capital and reserves

Profit before interest and tax

Interest cover =
Interest charges in the year

Investors Profits attributab le to ordinary shareholde rs

EarningPerShare =
Ratios No. of shares

Current market price per share

P/E ratio =
Earnings per share

Dividend yield = Dividend per share  100%

Current market price per share

Earnings per share Profit before dividends

Dividend cover = or
Dividend per share Dividends