Substantive procedures

1 Introduction

Substantive procedures are generally carried out during the final audit when the draft financial statements have been produced. Each material amount on the statements has to be audited for all relevant assertions.

To recap, methods of gathering evidence are:

• Analytical procedures
  

• Enquiry and confirmation
  

• Inspection
  

• Observation
  

• RecalcUlation and reperformance.
  

And the assertions are:

1.1 From objective to audit programme

An audit programme turns each objective into a procedure and records the evidence, exceptions and conclusion. The assertion tells you what the procedure must establish; naming a document without saying what to check is not a complete procedure.

This chapter looks at typical substantive procedures for:

• Inventory

• Trade and other receivables

• Bank and cash

• Trade and other payables

• Accruals and prepayments

• Tangible non-current assets

• Non-current liabilities

• Provisions and related contingent liabilities

2 Inventory

2.1 Introduction

Inventory is one of the most challenging items to audit. There are difficulties ensuring that the physical quantities are correct and then ensuring that inventory is properly valued at the lower of cost and net realisable value. Valuation is more involved than looking at purchase invoices for manufactured goods and work-in-progress.

2.2 Inventory counts (stock takes)

If inventory is material to the financial statements, it is normal to have a year-end stock take and the auditor will normally attend this. It is not the auditor’s responsibility to count the stock (that is the responsibility of client’s staff) but the auditor has to observe the stocktake and to ensure that it is being carried out correctly so that the results can be relied upon. The auditor will perform a few test counts only.

The normal sequence of a stock take and the auditor’s involvement is as follows:

• Instructions should be issued to client staff and they should be briefed about how the count should proceed. This is important because counts might be done only once per year so it is not a process with which staff are familiar. Many staff might not have been involved previously. The auditor must review the instructions and make recommendations to the client as necessary.
  

• The count should be planned for a date and time when stock movements are not taking place. New Year’s Day is often chosen (popular with both client staff and auditors!)
  

• Inventory has to be sorted, tidied and arranged in an orderly fashion. This might be relatively easy in a retail environment, but think how difficult it can be in an engineering company, a builder’s premises or a wood yard.
  

• Damaged inventory should be identified and labelled.
  

• Each inventory location should be labelled and the labels should have space for:
  

  • Location reference/description
    

  • Product code
    

  • Product description
    

  • Quantity counted
    

  • Count sheet number
    

  • Initials/signature of 1st counter
    

  • Initials/signature of 2nd counter
    

• Counters should be in teams of two. Both counters should not be from stores because they can have incentive to cover-up stock shortfalls. If both counters are from the accounting department, they are less likely to be able to identify properly what they are counting. A mixed pair is good: one from stores, one from accounts.
  

• Sequentially pre-numbered count sheets are issued to each counting team and the count progresses. The label in each inventory location is filled in as are the stock sheets with product description and quantities. The stock sheets and location labels are cross-referenced.
  

• The auditor should perform some test counts: from stock locations, recount and trace details to the count sheets (completeness assertion), and from stock sheets trace to stock locations and recount (existence assertion). Discrepancies should be noted.
  

• The auditor should make a note of the last few goods received notes and despatch notes issued before the count/year end. These will be used later for cut-off tests (see below).
  

• The auditor should be alert to any inventory that seems to be damaged and should make a note of this and raise the matter at the time with the manager in charge of the count.
  

• All count sheets should be collected in and the numerical sequence verified as being complete.
  

2.3 After the stocktake

When the stocktake is complete the company should have records of the physical quantities of inventory; this can be compared to book records (if any) and discrepancies investigated. Occasionally a recount of certain items might be needed.

The inventory now needs to be valued at the lower of cost and net realisable value.

The cost of purchased goods can be established by inspecting recent purchase invoices.

The cost of manufactured goods and work-in-progress should include material, labour and production overheads. The auditor will have to examine the cost accounting records to check on production times, wage rates and overhead absorption rates. Although the auditor can inspect WIP it will be difficult to ascertain its degree of completion. If material, the auditor may ask management for written representation about its completion stage (see Chapter 14).

Net realisable value is only relevant if this is lower than cost.

• The auditor should identify slow-moving lines of inventory by examining stock records and also by calculating days of inventory as at year end. An increase in this ratio might indicate that inventory will not sell easily and might have to be written down in value.
  

• The auditor will review records relating to damaged stock identified during the stock-take.
  

• The auditor can use analytical procedures to determine if the days of inventory seem to be high.
  

• The auditor can look at post year-end sales to ensure that the selling prices of inventory are above cost.
  

Once all costs/NRVs have been determined and entered on the count sheets, the value of each line of inventory can be worked out (eg quantity x cost) and the values added up. It is essential that the auditor reperforms these calculations. Remember, every extra $1 in inventory value is an extra $1 on profit.

2.4 Perpetual inventory

• Update perpetual inventory records for every receipt and issue. Count every inventory line at least once a year, spreading counts through the year.

• Rely on the records only when controls over movements, recording and counting are effective; investigate and correct differences.

• Assess and test those controls; observe selected counts, make test counts and inspect follow-up of discrepancies.

• Reconcile final records to the financial statements. Test movements between count dates and year end, including cut-off.

• Reliable records and controlled continuous counting can reduce the need for one complete year-end count. Evidence of year-end quantities and valuation is still required.

• If records are unreliable, differences unexplained or count controls weak, extend testing and request a full count.

2.5 Cut-off

Cut-off is one of the assertions: it means that transactions should be recorded in the correct period. For example, sales made in January 20X4 should not be included as revenue in the 12 months ended 31/12/20X3.

Correct cut-off on sales ensures consistency with receivables and inventory. Correct cut-off on purchases ensures consistency with payables and inventory.

For example, goods might have been despatched around 28/12/20X4, but not invoiced until January 20X5. Generally, the sale is to be recognised when goods are despatched. The goods will not have been counted in closing inventory at 31/12/20X4, yet the sale might not have been recognised until the invoice was issued in the following year (Dr Receivables Cr Sales).

Similarly, goods might have been received 27/12/20X4, but the invoice not received until January 20X5. The goods will be in closing inventory (they are physically present), but the purchase will not have been put through the accounts (Dr Purchases Cr Supplier) until the invoice is received.

For goods received just before year end:

• Goods will be in closing inventory
  

• Cost should be included in purchases
  

• Liability should be recognised.
  

If the invoice was received before year end, the liability (payable) will have been accounted for provided all invoices are posted. If the invoice is not received until after year end, an accrual should be established (ie Dr Purchases, Cr 'Goods received - not invoiced' accrual).

For goods received just after year end:

• Goods will not be in closing inventory
  

• If the invoice has been received before year end, this should not be recorded (as goods not yet received)
  

• There should be no asset in respect of these goods in closing inventory, no expense and no liability.
  

For goods despatched just before year end:

• Goods will not be in closing inventory
  

• Sale should be recognised in revenue
  

• A receivable should be recognised even if not invoiced until after year end
  

For goods despatched just after year end:

• Goods will be in inventory
  

• There is no sale in the current year
  

• Even if invoiced in advance, the amount should not be included in revenue or receivables. (Advance payments received for goods not despatched at the year end are a liability.)
  

3 Cash in hand and at bank

Cash is one of the easiest assets to audit. Most businesses will have a relatively immaterial amount of cash in hand (in the petty cash box), and that can be counted if necessary.

Some businesses, like retail businesses which keep cash for sales registers, will have more material amounts and some of these should be counted by the auditor on a test basis.

For most businesses, their material amounts of cash will be on deposit or in current accounts at their bank(s). The standard procedure is to obtain a 'bank report for audit purposes' ('bank certificate') from clients’ banks setting out the balances and any security that the bank has for loans. A bank certificate is very reliable audit evidence.

The amount certified by the bank is not necessarily the amount that will appear in the statement of financial position and a bank reconciliation will have to be performed by the client and re-performed by the auditor to ensure that the cash book balance (ie the amount in the financial statements) can be reconciled to the bank certificate.

4 Trade Receivables

4.1 Introduction

Receivables are likely to be material when businesses make sales on credit. A particular difficulty is to test the valuation assertion as sometimes receivables ‘go bad’ and will never be paid.

4.2 External confirmation

Assuming trade receivables are material, external confirmation procedures (a 'receivables circularisation') is used to obtain evidence about the existence and ownership of receivables.

First, the auditor must ensure that the receivables figure in the financial statements is based on the sum of individual customer balances. The assets being audited are the individual receivables balances – not the total balance. If the control account and the sum of the individual balances do not reconcile, there is no basis for the receivables figure in the financial statements.

Then a sample of receivables balances is chosen. Typically this will be a stratified sample. Say that the receivables balances were as follows:

A typical sample might be:

• All the customers owing >$100,000
  

• 50% of those owing $20,000 – $100,000
  

• 50 balances from those owing <$20,000
  

In addition, customers with credit balances and very old balances would be circularised, as would a selection of customers with Nil balances.

A request for confirmation will usually include management's authorisation or encouragement for the customer to disclose confidential information to the auditor. The auditor must have control over sending the requests and receive responses directly.

There are two types of confirmation request:

• Positive   –   requests a reply from everyone who has been written to, whether or not they agree with the balance. This is most suitable where the risk of misstatement is high (e.g. weak internal controls, errors expected or suspicion of irregularity or disputed amounts).
  

• Negative   –   requests a reply only if the customer disagrees with the balance. This type is appropriate when control risk is low (i.e. errors are not expected), there is a large proportion of smaller balances and customers are not expected to ignore the request.
  

A positive request provides more conclusive evidence. For a negative request, the auditor can never be sure that no reply means agreement rather than that the customer has simply not bothered to reply.

A schedule is maintained of replies, showing agreements and disagreements. Disagreements can often be explained by timing differences. For example, the client issues an invoice 29/12 but that wasn’t processed by their customer until 2/1.

If sending positive requests (only), after a couple of weeks, with the client’s permission, customers who have not replied will be sent a reminder letter by the auditor. If there is still no reply then, for very material receivable balances, and again with client’s permission, the auditor might attempt to get telephone confirmation.

4.3 Valuation of receivables

Even if a positive reply confirms agreement of amounts owing (which is important) it does not give any assurance that the debt will be paid.

The valuation assertion can be addressed by:

• Examining aged receivables reports. Allowances may need to be made for overdue debts and very old debts should be written off if expected to be irrecoverable.
  

• Performing analytical procedures on receivables balances. For example, average collection period (days).
  

• Reviewing cash receipts after year end. If the full amount is received after year end there is obviously no valuation problem at year end.
  

• Reviewing correspondence with customers and lawyers for evidence of disputed amounts that may not be paid.
  

• Reviewing board minutes (large debts that might go bad are probably discussed at board meetings).
  

4.4 After year end credit notes

Credit notes issued in the first month or so after year end should be scrutinised to ensure that any sales and receivables balances as at year end are reduced appropriately. Occasionally, it is found that an invoice has been deliberately raised and posted before year end then a credit note issued against it after year end as a mechanism for fraudulently boosting sales.

5 Trade payables

5.1 Introduction

Many of the audit procedures that are carried out on trade payables balances are similar in principle to those that are carried out on receivables balances. However, the auditor will be most concerned about the completeness assertion - how to detect a liability (and corresponding expense) that is missing? The first essential step is to ensure that the trade payables figure in the financial statements reconciles to the sum of the individual payables balances.

5.2 Supplier statements

In many countries it is common for suppliers to send monthly statements of account to their customers. An important internal control is that the client should reconcile these statements to the individual payables balances. Reconciling items might include:

• Cash-in-transit (ie payments by client not received by supplier)
  

• Goods-in-transit (ie goods invoiced by supplier not received by the client)
  

• Disputed invoices - if the dispute is valid, the invoice should be subsequently cancelled with a credit note from the supplier.
  

The auditor will generally reperform a sample of reconciliations.

If monthly statements are not available, the auditor may send a request to suppliers asking for a statement and then reconcile the balances.

5.3 Post year end payments

Payments made in the first month or so after year end should be examined. Payments will be traced to purchase invoices and, if they relate to an expense in the year being audited, they must be included in either the payables ledger or accrued expenses.

5.4 Analytical procedures

Analytical procedures such as the calculation of payables days and comparison with previous ratios might indicate that payables are incorrect.

5.5 Written representation

Because of the difficulty in ensuring that all liabilities have been included, in addition to the work described above, it is normal to ask management to give a written representation to the effect that all liabilities have been included in the financial statements. (see Chapter 14)

6 Accruals and prepayments

6.1 Introduction

These are often, but not always relatively small amounts. If so audit work can be kept to a minimum. Very often they will be similar to previous year’s figures.

6.2 Prepayments

• Look at the previous year’s audit file. Many payments are standard (eg car insurance always paid 1 June for the next 12 months) so there is an expectation for this year’s prepayments to be similar to last period’s (adjusted for inflation).
  

• Inspect invoices paid in the last few months of the period (where more months likely to be prepaid).
  

6.3 Accruals

• Look at the previous year’s audit file. Many payments are standard (eg electricity always paid 28/2 for the previous three months), so there is an expectation for this year’s accruals to be similar to last period’s (adjusted for inflation).
  

• Inspect invoices and payments in the first few months after the year end. If they relate to expenses in the current year and are not included in the payables ledger at the year end, they must be accrued.
  

• Include a representation about the completeness of liabilities in the letter of representation.

6.4 Other receivables and other payables

Obtain schedules and reconcile totals to the general ledger. For a deposit or other receivable, inspect the agreement, confirm the counterparty and check later recovery for existence, rights and valuation. For other payables, inspect contracts, tax or other supporting calculations and later settlement. Search post-year-end invoices and payments for omitted amounts, and check cut-off, accruals and presentation. Do not assume a non-trade balance is immaterial merely because it is labelled “other”.

7 Non-current assets

7.1 Acquisitions and disposals

Verify amounts by inspecting sale and purchase agreements and invoices.

Large movements should be referred to in board minutes.

7.2 Ownership

Verify ownership by inspecting documents of title, such as land registry entries for land and buildings.

7.3 Existence and completeness.

Verify existence by inspecting assets. Verify completeness by reconciling the figures in the financial statements to the sum of the items in the non-current ('fixed') asset register.

7.4 Valuation

Verify valuation by inspecting depreciation rates and ensuring these are in line with industry norms and are consistent with previous years. Recalculate depreciation for a sample of assets.

Perform a 'test in total' (an example of an analytical procedure) to verify that the total depreciation expense for each type of asset is reasonable.

Inspect assets to ensure that they appear to be in working order and that they are still used by the company.

Obtain management's written representations that they do not intend to dispose of major assets in the near future (eg by closing down part of the business). That might require the assets to be carried at a disposal value rather than cost less depreciation.

8 Non-current liabilities

• Obtain a loan/borrowing schedule and reconcile it to the general ledger and financial statements. Confirm balances and terms directly with lenders under the auditor’s control.

• Inspect loan agreements and board approval; verify new borrowing and repayments to bank records and search for unrecorded borrowing.

• Recalculate interest and accrued interest from the contractual rate and outstanding balance.

• Check repayment dates and loan-covenant compliance: a breach can affect current/non-current classification. Inspect security and verify the required disclosures.

9 Provisions

A provision is a recognised liability with uncertain timing or amount. For example, litigation can require a provision where there is a present obligation, probable outflow and a reliable estimate.

• Obtain the provision schedule and reconcile it to the ledger. Understand the obligation and inspect contracts, board minutes, legal correspondence and later payments. Seek direct legal evidence where appropriate.

• Evaluate the method, assumptions and data supporting management’s best estimate; recalculate the amount and consider alternative outcomes and management bias.

• Search minutes, claims and post-year-end correspondence for omitted provisions. Check recognition, classification and disclosures and obtain supporting written representations; representations do not replace other evidence.

10 Contingent liabilities: related background

10.1 Contingent liabilities

A contingent liability is a possible liability arising from past events but the existence of that liability will only be confirmed by future events.

An example is a damages claim against the company.

• Date of incident that might give rise to damages: 12/07/20X4
  

• Year end date: 31/12/20X4.
  

• Court case to be heard on 30/9/20X5
  

So, for the financial statements to 31/12/20X4, the event has happened. However, the outcome of the court case will not be known until long after the year end and after the audit will be complete.

Accounting for contingent liabilities depends on the likelihood (probability) of having to make a payment to settle it:

• If probable (ie >50%) - make a provision in the financial statements
  (ie Dr Expense Cr Liabilities).
  

• If possible (i.e. < 50% but not unlikely) - disclose in the notes to the financial statements
  (ie no provision).
  

• If remote (ie very unlikely) - make no reference to the matter at all.
  

The auditor has to collect evidence about the likelihood that an amount will have to be paid and the best estimate of that amount (unless the likelihood is remote).

Evidence can be obtained from:

• Board minutes
  

• Correspondence with the claimant and his/her lawyers
  

• Correspondence with the client’s own lawyers
  

• Written representations.
  

Occasionally, the auditor might seek expert evidence directly by asking a suitably experienced lawyer for an opinion.