Question

You are a trainee auditor and work for an audit firm in Hong Kong called Admiralty Partners. It is the middle of January and you are auditing at your client, Angel Ltd. a company which sells products to customers on credit. Your manager has asked you to perform the substantive audit testing of trade receivables at Angel Ltd.

While you are at Angel Ltd. the managing director asks to see you. She would like to know some detail of what your auditing colleagues were doing when they visited Angel Ltd. during the previous October. Her understanding is that this was a planning visit by the auditors but would like to have more detail of what activities were carried out in particular in relation to the work performed on controls testing. She does not understand why you are at the business in January doing even more testing and asks why this could not have been performed in the previous October visit. She also would like to understand the role of analytical review in the auditor’s work.

REQUIRED:

Write a memo to the Managing Director of Angel Ltd. discussing the purpose of each of walk through testing; controls testing and substantive testing.(for valid and clear discussion of each testing category required.)

Answer 1

Respected Madam,

A Controls testing is an audit procedure to test the effectiveness of a control used by a client entity to prevent or detect material misstatements. Depending on the results of this test, auditors may choose to rely upon a client's system of controls as part of their auditing activities. However, if the test reveals that controls are weak, the auditors will enhance their use of substantive testing, which usually increases the cost of an audit. The following are general classifications of tests of controls:

Reperformance: Auditors may initiate a new transaction, to see which controls are used by the client and the effectiveness of those controls.

Observation: Auditors may observe a business process in action, and in particular the control elements of the process.

Inspection: Auditors may examine business documents for approval signatures, stamps, or review check marks, which indicate that controls have been performed.

If the inspection approach is used, a test of controls is typically conducted for a sample of documents related to transactions that occurred throughout the year. Doing so provides evidence that the system of controls has operated in a reliable manner throughout the reporting period.

A test of controls is made irrespective of the dollar amount of the underlying business transaction. The main point of the test is to see if a control functions properly, so the dollar amount of a transaction is not of consequence to the goal of the test.

If the auditors encounter an error in a test of controls, they will expand the sample size and conduct further testing. If additional errors are found, they will consider whether there is a systematic controls problem that renders the controls ineffective, or if the errors appear to be isolated instances that do not reflect upon the overall effectiveness of the control in question.

Whereas, Substantive testing is an audit procedure that examines the financial statements and supporting documentation to see if they contain errors. These tests are needed as evidence to support the assertion that the financial records of an entity are complete, valid, and accurate. There are many substantive tests that an auditor can use. The following list is a sampling of the available tests:

• Issue a bank confirmation to test ending cash balances
• Contact customers to confirm that accounts receivable balances are correct
• Observe the period-end physical inventory count
• Confirm the validity of inventory valuation calculations
• Confirm with experts that the fair values assigned to assets obtained through a business combination are reasonable
• Physically match fixed assets to fixed asset records
• Contact suppliers to confirm that accounts payable balances are correct
• Contact lenders to confirm that loan balances are correct
• Review board of directors minutes to verify the existence of approved dividends

As indicated by the examples, substantive testing is likely to include confirmation of account balances with third parties (such as confirming receivables), recalculating calculations made by the client (such as valuing inventory), and observing transactions being performed (such as the physical inventory count).

If substantive testing turns up errors or misstatements, additional audit testing may be required. In addition, a summary of any errors found is included in a management letter that is shared with the client's audit committee.

Thus, in order to reduce the number of errors due to lack of controls and to ensure that the Financial Statements are free from material misstatements, both control testing and substantive testing is essential for every period covered in the audit.

Thanking you.

Yours faithfully,

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