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(Objective 13-2) Rank the following types of tests from most costly to least costly: analytical procedures, tests of details of balances, risk assessment procedures, tests of controls, and substantive tests of transactions.
SELECTING WHICH TYPES OF TESTS TO PERFORM
Typically, auditors use all five types of tests when performing an audit of the financial state ments, but certain types may be emphasized, depending on the circumstances. Recall that risk assessment procedures are required in all audits to assess the risk of material misstatement while the other four types of tests are performed in response to the risks identified to provide the basis for the auditor’s opinion. Note also that only risk assess ment procedures, especially procedures to obtain an understanding of controls, and tests of controls are performed in an audit of internal control over financial reporting. Several factors influence the auditor’s choice of the types of tests to select, including the availability of the eight types of evidence, the relative costs of each type of test, the effectiveness of internal controls, and inherent risks. Only the first two are discussed further because the last two were discussed in earlier chapters. Each of the four types of further audit procedures involves only certain types of evidence (confirmation, documentation, and so forth). Table 13-2 summarizes the rela – tionship between further audit procedures and types of evidence. We can make several observations about the table:
• More types of evidence, six in total, are used for tests of details of balances than for any other type of test.
• Only tests of details of balances involve physical examination and confirmation.
• Inquiries of the client are made for every type of test.
• Documentation is used in every type of test except analytical procedures.
• Reperformance is used in every type of test except analytical procedures. Auditors may reperform a control as part of a transaction walkthrough or to test a control that is not supported by sufficient documentary evidence.
• Recalculation is used to verify the mathematical accuracy of transactions when per forming substantive test of transactions and account balances when per – forming tests of details of balances.
When auditors must decide which type of test to select for obtaining sufficient appro – priate evidence, the cost of the evidence is an important consideration. The types of tests are listed below in order of increasing cost:
• Analytical procedures
• Risk assessment procedures, including procedures to obtain an understanding of internal control
• Tests of controls
• Substantive tests of transactions
• Tests of details of balances
Analytical procedures are the least costly because of the relative ease of making calculations and comparisons. Often, considerable information about potential mis – statements can be obtained by simply comparing two or three numbers. Risk assessment procedures, including procedures to obtain an understanding of internal control, are not as costly as other audit tests because auditors can easily make inquiries and observations and perform planning analytical procedures. Also, examining such things as documents summarizing the client’s business operations and processes and management and governance structure are relatively cheaper than other audit tests. Because tests of controls also involve inquiry, observation, and inspection, their relative costs are also low compared to substantive tests. However, tests of controls are more costly relative to the auditor’s risk assessment procedures due to a greater extent of testing required to obtain evidence that a control is operating effectively, especially when those tests of controls involve reperformance. Often, auditors can perform a large number of tests of controls quickly using audit software. Such software can test controls in clients’ computerized accounting systems, such as in computerized accounts receivable systems that automatically authorize sales to existing customers by comparing the proposed sales amount and existing accounts receivable balance with the customer’s credit limit. Substantive tests of transactions cost more than tests of controls that do not include reperformance because the former often require recalculations and tracings. In a computerized environment, however, the auditor can often perform substantive tests of transactions quickly for a large sample of transactions. Tests of details of balances almost always cost considerably more than any of the other types of procedures because of the cost of procedures such as sending confirma – tions and counting inventories. Because of the high cost of tests of details of balances, auditors usually try to plan the audit to minimize their use. Naturally, the cost of each type of evidence varies in different situations. For example, the cost of an auditor’s test-counting inventory (a substantive test of the details of the inventory balance) often depends on the type and dollar value of the inventory, its location, and the number of different items. To better understand tests of controls and substantive tests, let’s examine how they differ. An exception in a test of control only indicates the likelihood of misstatements affecting the dollar value of the financial statements, whereas an exception in a substantive test of transactions or a test of details of balances is a financial statement misstatement. Exceptions in tests of controls are called control test deviations. From Chapter 10, you may recall the three levels of control deficiencies: deficiencies, significant deficiencies, and material weaknesses. Auditors are most likely to believe material dollar misstatements exist in the financial statements when control test deviations are considered to be significant deficiencies or material weaknesses. Auditors should then perform substantive tests of transactions or tests of details of balances to determine whether material dollar misstatements have actually occurred. Assume that the client’s controls require an independent clerk to verify the quantity, price, and extension of each sales invoice, after which the clerk must initial the duplicate invoice to indicate performance. A test of control audit procedure is to inspect a sample of duplicate sales invoices for the initials of the person who verified the information. If a significant number of documents lack initials, the auditor should consider implications for the audit of internal control over financial reporting and follow up with substantive tests for the financial statement audit. This can be done by extending tests of duplicate sales invoices to include verifying prices, extensions, and footings (substantive tests of transactions) or by increasing the sample size for the confirmation of accounts receivable (substantive test of details of balances). Even though the control is not operating effectively, the invoices may still be correct, especially if the person originally preparing the sales invoices did a conscientious and competent job. On the other hand, if no documents or only a few of them are missing initials, the control will be considered effective and the auditor can therefore reduce substantive tests of transactions and tests of details of balances. However, some reperformance and recalculation substantive tests are still necessary to provide the auditor assurance that the clerk did not initial documents without actually performing the control procedure or performed it carelessly. Because of the need to complete some reperformance and recalculation tests, many auditors perform them as a part of the original tests of controls. Others wait until they know the results of the tests of controls and then determine the total sample size needed. Like tests of controls, analytical procedures only indicatethe likelihood of misstatements affecting the dollar value of the financial statements. Unusual fluctuations in the relationships of an account to other accounts, or to nonfinancial information, may indicate an increased likelihood that material misstatements exist without necessarily providing direct evidence of a material misstatement. When analytical procedures identify unusual fluctuations, auditors should perform substantive tests of transactions or tests of details of balances to determine whether dollar misstatements have actually occurred. If the auditor performs substantive analytical procedures and believes that the likelihood of material misstatement is low, other substantive tests can be reduced. For accounts with small balances and only minimal potential for material misstatements, such as many supplies and prepaid expense accounts, auditors often limit their tests to substantive analytical procedures if they conclude the accounts are reasonably stated. There is a trade-off between tests of controls and substantive tests. During planning, auditors decide whether to assess control risk below the maximum. When they do, they must then perform tests of controls to determine whether the assessed level of control risk is supported. (They must always perform test of controls in an audit of internal control over financial reporting.) If tests of controls support the control risk assess – ment, planned detection risk in the audit risk model is increased, and planned substantive tests can therefore be reduced. Figure 13-3 shows the relationship between substantive tests and control risk assessment (including tests of controls) at differing levels of internal control effectiveness.
The shaded area in Figure 13-3 (p. 411) is the maximum assurance obtainable from control risk assessment and tests of controls. At any point to the left of point A, assessed control risk is 1.0 because the auditor initially evaluated internal controls as ineffective based on the performance of risk assessment procedures. Any point to the right of point B results in no further reduction of control risk because the CPA firm has established a minimum assessed control risk. Notice in Figure 13-3 that regardless of the level of audit assurance obtained from control risk assessment and tests of controls, an audit of finan – cial statements always requires some substantive pro cedures. Because the audit of financial statements and the audit of internal control over financial reporting are integrated, accelerated filer public company audits will most likely be represented by point B. The auditor’s understanding of internal control performed as part of risk assess – ment procedures provides the basis for the auditor’s initial assessment of control risk. Assuming that the auditor determines that the design of internal control is effective and the controls are implemented, the auditor selects a point within the shaded area of Figure 13-3 that is consistent with the assessed control risk the auditor decides to support with tests of controls. Assume the auditor contends that internal control effectiveness is at point C. Tests of controls at the C1 level will be extensive to support the low assessment of control risk. The auditor may then determine through the performance of tests of controls that the initial low assessment of control risk at point C is not supported and that internal control is not operating effectively. Then, the auditor’s revised control risk assessment would be at the maximum (point C3) and audit assurance will be obtained from substantive tests. Any point between the two, such as C2, represents situations where the audit assurance obtained from tests of controls is less than the maximum level of assurance represented by point C1. If C2 is selected, the audit assurance from tests of controls is C3 – C2 and from substantive tests is C – C2. The auditor will likely select C1, C2, or C3 based on the relative cost of tests of controls and substantive tests.
The choice of which types of tests to use and how extensively they need to be performed can vary widely among audits for differing levels of internal control effectiveness and inherent risks. Even within a given audit, variations may occur from cycle to cycle. To obtain sufficient appropriate evidence in response to risks identified through risk assessment procedures, auditors employ a combination of the four remaining types of tests. This combination is often called the evidence mix, which is illustrated in Table 13-3 for four different audits. In each case, assume that sufficient appropriate evidence was accumulated. In each audit, you should be able to determine the description of the client from the evidence mix in Table 13-3. Analysis of Audit 1 This client is a large company with sophisticated internal controls and low inherent risk. Therefore, the auditor performs extensive tests of controls and relies heavily on the client’s internal controls to reduce substantive tests. Extensive substantive analytical procedures are also performed to reduce other substantive tests. Substantive tests of transactions and tests of details of balances are therefore minimized. Because of the emphasis on tests of controls and substantive analytical procedures, this audit can be done relatively inexpensively. This audit likely represents the mix of evidence used in the integrated audit of a public company’s financial statements and internal control over financial reporting. Analysis of Audit 2 This company is medium sized, with some controls and a few inherent risks. The auditor has decided to do a medium amount of testing for all types of tests except substantive analytical procedures, which will be done extensively. More extensive testing will be required if specific inherent risks are discovered.
Analysis of Audit 3 This company is medium sized but has few effective controls and significant inherent risks. Perhaps management has decided that better internal controls are not cost effective. Because of the lack of effective internal control, we can assume this company is probably a nonpublic company. No tests of controls are done because reliance on internal controls is inappropriate when controls are insufficient for a nonpublic company. The auditor emphasizes tests of details of balances and sub – stantive tests of transactions, but some substantive analytical procedures are also done. Substantive analytical procedures are usually performed to reduce other substantive tests because they provide evidence about the likelihood of material mis statements. If the auditor already expects to find material misstatements in the account balances, additional analytical procedures are not cost effective. The cost of the audit is likely to be relatively high because of the amount of detailed substantive testing. Analysis of Audit 4 The original plan on this audit was to follow the approach used in Audit 2. However, the auditor likely found extensive control test deviations and significant misstatements while performing substantive tests of transactions and substantive analytical procedures. Therefore, the auditor concluded that the internal controls were not effective. Extensive tests of details of balances are performed to offset the unacceptable results of the other tests. The cost of this audit is higher because tests of controls and substantive tests of transactions were performed but can not be used to reduce tests of details of balances.