7013 Select the appropriate type of substantive procedures to perform

Sep-2022

OAG Guidance

Determining the appropriate mix of substantive procedures to perform depends on the desired level of evidence. This is an area of professional judgment to identify those substantive procedures that would be the most effective and efficient to perform to obtain the evidence sought in respect of the relevant assertions. This process includes the involvement of engagement team members with the appropriate level of experience, and depends on the assessment of the risk of material misstatement, the likelihood that a material misstatement will occur, the characteristics of the significant class of transactions, account balance or disclosure involved, the nature of the specific controls used by the entity, in particular, whether they are manual or automated, and whether the auditor expects to obtain audit evidence over the operating effectiveness of those controls. As the risk of material misstatement for a given assertion increases, the reliability of the audit evidence needed to respond to it also increases. For example, you may determine that there is a relatively high risk of material misstatement related to the valuation of goodwill but a relatively low risk related to the valuation of fixed assets. Design the substantive procedures to address the valuation of goodwill to provide more relevant and reliable audit evidence than those performed related to the valuation of fixed assets.

Tests of details are ordinarily more appropriate to obtain audit evidence regarding certain assertions about account balances, such as existence and valuation. In some situations, we may determine that performing only substantive analytical procedures may be sufficient to reduce the risk of material misstatement to an acceptably low level. This might apply to the assessed risk of material misstatement for a class of transactions where the assessment of risk is supported by audit evidence of the operating effectiveness of controls.

When we design our audit procedures, we are aware of the risk associated with the relevant assertions. Although all assertions may be relevant to an FSLI, not all relevant assertions will have the same level of risk associated with them. For example, if we have identified a risk that the client attempts to minimize their tax liability, our risk associated with the occurrence assertion for expenses will be higher than the risk associated with completeness. Our audit plan reflects this difference. Also, simply because an elevated or significant risk has been identified for the occurrence assertion, does not mean that multiple tests would be required to address that assertion. Instead, we design effective and efficient procedures (e.g., a combination of substantive analytics and targeted testing) to address the assertion.

For significant risks of material misstatement, it is unlikely that audit evidence obtained from substantive analytical procedures alone will be sufficient. In such cases, we also consider whether tests of details are needed for us to be satisfied with respect to the related relevant financial statement assertions and material accounts and disclosures.

Example of how to allocate planning materiality to your overall testing approach

The purpose of this guidance is to provide examples of how to allocate performance materiality to common scenarios. Generally materiality will be allocated at the FSLI level. In the examples below use revenue as an example but the principles can be applied to other FSLIs as well. Allocating performance materiality requires judgement and these examples should not be applied without considering the specific facts relating to your client.

For further guidance or questions on this matter, please contact Audit Services.

Examples

Example 1—non-statistical sampling

Allocating performance materiality to non‑statistical sampling is done through the application of a tolerable error in the non‑statistical testing template.

In this example, total revenue is $35M and 100% of revenue relates to sales of Product A.

Materiality = $700k

Performance materiality = $630k

Assuming 100% of the revenue will be tested using non‑statistical sampling, what tolerable error could you use for your non‑statistical test?

Solution

In this case, as 100% of the balance will be tested through one non‑statistical test, the tolerable error can be set equal to performance materiality of $630k

Revenue	Amount	Testing approach	Tolerable error
Sales of product A	$35 million	Non-statistical testing	$630k

Example 2—Multiple non-statistical sampling

If we consider the same facts as Example 1, but in this example, total revenue of $35M is made up of sales of Product A and Product B:

Revenue	Amount	Testing approach
Sales of product A	$25 million	Non-statistical testing
Sales of product B	$10 million	Non-statistical testing
Total revenue	$35 million

Assuming each stream of revenue will be tested through non‑statistical sampling, what tolerable error could you use for each of the non‑statistical tests?

Solution

Similar to Example 1, as 100% of the balance will be tested through non‑statistical testing, the tolerable error can be set equal to performance materiality of $630k for each non‑statistical test.

Revenue	Amount	Testing approach	Tolerable error
Sales of product A	$25 million	Non-statistical testing	$630k
Sales of product B	$10 million	Non-statistical testing	$630k
Total revenue	$35 million	Non-statistical testing

Example 3—Target testing plus non-statistical testing

If we consider the same facts as in Example 2 except that in this example, there is a third revenue stream. Sales of product C consists of three transactions amounting to $2M each.

Revenue	Amount	Testing approach
Sales of product A	$19 million	Non-statistical testing
Sales of product B	$19 million	Non-statistical testing
Sales of product C	$6 million	Target testing (100%)
Total revenue	$35 million

How could performance materiality be allocated across your testing?

Solution

The solution for this example is the same as Example 2. Allocating performance materiality or determining a tolerable error is not required for target testing. Any differences noted during target testing if above SUM are brought to the SUM sheet. Therefore using a tolerable error equal to performance materiality of $630k for each non‑statistical test is appropriate.

Revenue	Amount	Testing approach	Tolerable error
Sales of product A	$19 million	Non-statistical testing	$630k
Sales of product B	$19 million	Non-statistical testing	$630k
Sales of product C	$6 million	Target testing (100%)
Total revenue	$35 million

Example 4—Target testing, non-statistical testing and a substantive analytic

If we consider the details in Example 3 but we add a fourth revenue stream—Product D. Product D will be tested using substantive analytics and the testing approach for Products A, B and C will remain consistent with Example 3.

Revenue	Amount	Testing approach
Sales of product A	$16 million	Non-statistical testing
Sales of product B	$10 million	Non-statistical testing
Sales of product C	$6 million	Target testing (100%)
Sales of product D	$3 million	Substantive analytics
Total revenue	$35 million

For a substantive analytics, in addition to considering Performance Materiality, teams also need to consider the desired level of evidence from the analytical procedure, the precision of the expectation and the type of analytical procedure and the rigor with which it is applied as discussed in OAG Audit 7033.2.

Teams need to use judgement to determine what the appropriate tolerable error (or threshold) is for the substantive analytic. In this case, let’s assume the appropriate threshold is $100k. How would performance materiality be allocated across the rest of your testing?

Solution

Consistent with example 3, the target testing will not have a threshold. So what tolerable error will we use for the non‑statistical sampling? The key message is that with the allocation of the performance materiality to the substantive analytic, the tolerable error for each of the non‑statistical sampling tests needs to be reduced. Engagement teams need to use their judgement in determining how much to reduce the tolerable error. In this example, an engagement team may conclude that reducing the tolerable error in each of the non‑statistical tests to $600k each is appropriate. This number is judgemental and should be based on the facts and circumstances of your specific engagement.

Revenue	Amount	Testing approach	Tolerable error
Sales of product A	$16 million	Non-statistical testing	$600k
Sales of product B	$10 million	Non-statistical testing	$600k
Sales of product C	$6 million	Target testing (100%)
Sales of product D	$3 million	Substantive analytics
Total revenue	$35 million

Example 5—Target testing, non-statistical testing, substantive test and an untested balance

Now what if there was a fifth revenue stream, sales of product E but we determined that this revenue stream would not be tested as the risk was sufficiently low and the balances was immaterial. Would this change how we allocate performance materiality from Example 4?

Revenue	Amount	Testing approach
Sales of product A	$15.5 million	Non-statistical testing
Sales of product B	$10 million	Non-statistical testing
Sales of product C	$6 million	Target testing (100%)
Sales of product D	$3 million	Substantive analytics
Sales of product E	$0.5 million	Untested
Total revenue	$35 million

Solution

We normally would not go through the process of calculating a tolerable error relating to an untested balance in our files however we do need to consider the impact it has on our overall testing approach.

For an untested balance, you would need to consider the balance untested and the risk associated with the untested balance including among other things the nature of transactions and the aggregation risk within the untested balance. Generally you would not expect the allocation of performance materiality to change much from example 4 for an untested balance as the balance by its nature would need to be very low risk. In this example, an engagement team may conclude that the allocation of performance materiality or tolerable error, does not need to be adjusted as they might be able to conclude that the risk related to the untested balance is sufficiently low and therefore, any impact on the tolerable error would be minimal. However if there is more than a low amount of risk associated with the untested balance, teams should consider reducing the tolerable error for each of the non‑statistical test to something less than $600k. In this case we will say $590k.

Revenue	Amount	Testing approach	Tolerable error
Sales of product A	$15.5 million	Non-statistical testing	$590k
Sales of product B	$10 million	Non-statistical testing	$590k
Sales of product C	$6 million	Target testing (100%)
Sales of product D	$3 million	Substantive analytics
Sales of product E	$0.5 million	Untested
Total revenue	$35 million

General considerations

The total tolerable error determined in a combined testing approach can exceed overall performance materiality. As noted, teams should use their professional judgement when determining what tolerable error is appropriate.

There is no ‘one’ correct answer. Judgement is involved in determining the tolerable error to be used however the key is to understand that as your untested balance increases and as the balance tested through substantive analytics increases, the tolerable misstatement for non‑statistical sampling should decrease.

OAG Guidance

As we develop our substantive test plan, consider the evidence obtained from the testing of balance sheet items when determining the evidence needed on income statement balances.

Following the double-entry principle, procedures that are performed on balance sheet line items may contribute to our evidence on the income statement, particularly where the transactions are settled. Our documentation clearly reflects any links we made between the results of our testing of balance sheet items and the consequent extent of testing on the income statement.

Balance sheet and other basic procedures that may contribute to the occurrence and/or accuracy assertion for revenue

• Accounts receivable confirmations or testing of cash collections
• Testing of post year end credit notes/returns (also cut-off)
• Accounts receivable/revenue cut-off testing
• Bank reconciliation testing and cash book review
• Review of journal entries and manual adjustments for revenue items
• Review of relevant ratios, e.g. debtors days

Procedures that contribute to the completeness assertion for revenue

• Accounts receivable/revenue cut-off testing (including review of shipment activity around period-end; also cut-off assertion)

• Deferred revenue testing

• Bank reconciliation testing

Procedures that contribute to the completeness and/or accuracy and/or occurrence assertion for cost of sales and expenses

• Search for unrecorded liabilities
• Cut-off testing
• Reconciling supplier statements to the accounts payable listing/sub-ledger
• Physical inventory observations
• Testing of inventory valuations
• Testing of prepaid expenses
• Review of journal entries and manual adjustments
• Relevant ratios, e.g., gross profit margins, finished goods turnover ratio or days cost of sales in inventory

Consider the results from the above procedures when we determine an effective and efficient audit strategy for our income statement testing.