Chapter 8

PERFORMING SUBSTANTIVE TESTS

After considering inherent risk and control risk, the auditor

performs substantive tests to reduce the level of detection risk to
an acceptable level.

Substantive tests are audit procedures designed to substantiate the

account balances or to detect material misstatements in the financial
statements. There are two types of substantive tests, namely analytical
procedures and test of details. The decision about which procedures to
use is based on the auditor's judgment about the expected effectiveness
and efficiency of such procedures in satisfying the audit objective.

Analytical Procedures

As discussed in Chapter 5, analytical procedures may be used in

the planning, testing and overall review stages of the audit.
Analytical procedures applied as substantive tests enable the
auditor to obtain corroborative evidence about a particular
account. This approach involves comparison of financial
information with auditor's expectations to determine the

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reasonableness of an account balance reported in a financial
statement.

When analytical procedures identify significant fluctuations, the

auditor should conduct further investigation to determine whether
the financial statements are materially misstated. This
investigation ordinarily begins with inquiries of management
followed by corroboration of management's responses and other
audit procedures based on the results of these inquiries.

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The effectiveness of analytical procedures applied as substantive tests
is affected by many factors such as the nature of the assertions,
reliability of data used to develop expectations, precision of
expectations, and predictability of the account balances.

When intending to perform analytical procedures as substantive tests,

the auditor should focus on those accounts that are predictable. The
following generalizations may be helpful in assessing the
predictability of the accounts.

 Income statement accounts are more predictable compared to

balance sheet accounts.
 Accounts that are not subject to management discretion are
generally predictable.
 Relationships in a stable environment are more predictable than
those in a dynamic or unstable environment

Test of details

Test of details involves examining the actual details making up the

various account balances. This approach may take the form of test of
details of balances or test of details of transactions. Test of details of
balances involves direct testing of the ending balance of an account,
while test of details of transactions involves testing the transactions
which give rise to the ending balance of an account.

To illustrate the difference between the two forms, assume that the
auditor wants to examine the cash account.

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To substantiate the validity of the cash account, the auditor may directly
test the ending balance of cash (P1,500,000) by counting the cash on
hand and testing the bank reconciliation prepared by the client.

Alternatively, the auditor may also obtain evidence about the validity of
the cash account balance by examining the individual transactions
(receipts of P12,000,000 and disbursements of P11,500,000) affecting the
cash account that transpired during the year. This approach, however, will
be impractical since there are many transactions that occurred during the
year and most of these transactions are probably immaterial to the
financial statements taken as a whole.

In general, test of balances will be used when account balances are

affected by large volume of relatively immaterial transactions. Examples
of accounts of this type include cash, accounts receivable and inventory.

On the other hand, test of transactions is useful if account balances are

comprised of a smaller volume of transactions representing relatively
material amounts. Examples of these accounts are property and
equipment, intangibles, bonds payable, and stockholders’ equity accounts.

Effectiveness of Substantive Tests

The potential effectiveness of the auditor’s substantive test is affected by

its nature, timing, and extent.

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Nature of substantive test

The nature of substantive test relates to the quality of evidence.

The auditor should determine the appropriate quality of evidence
needed to support the desired level of detection risk. Although the
auditor would normally prefer high quality evidence, it is
important to realize that high quality evidence would also involve
high cost.

Timing of substantive test

Substantive tests may be performed at interim date or at year end.

Interim procedures are generally considered less effective due to
incremental audit risk involved when auditing interim balances.
Thus, the higher the risk of material misstatement, the more likely
it is that auditor may decide to perform substantive tests closer to
year-end.

Performing audit procedures at interim date assists the auditor in

identifying significant matters at an early stage of the audit, and
consequently resolving them with the help of management or
developing an effective audit approach to address such matters.
Additionally, performing interim procedures allows the auditor to
spread the work throughout the year thereby minimizing the load
during the peak period.

Extent of substantive test

The extent of substantive test relates to the amount of evidence

needed to satisfy a particular objective. The extent of substantive
tests is based on the auditor’s judgement after considering the
materiality, the assessed risk, and the degree of assurance the
auditor plans to obtain. In particular, the auditor ordinarily

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 increases the extent of substantive procedures as the risk of
material misstatement increases.

Relationship between Substantive Test and Test of Control

An understanding of the nature of substantive tests and tests of

control is essential in order to appreciate the relationship between
the two tests.

Test of controls provide evidence that indicates a misstatement is likely

to occur. Substantive tests, on the other hand, provide evidence about the
existence of misstatement in an account balance.

For example, if the results of tests of control indicate that the internal
control procedures are not functioning effectively, the auditor will
assume that material misstatements are likely to occur. The auditor will
then perform substantive tests to determine whether material
misstatements actually do exist.

In expressing an opinion on the financial statements, the auditor relies on

the effectiveness of the internal control to prevent material errors in the
accounting process, and on substantive tests to verify the amounts in the
financial statements. If tests of controls indicate that the internal control
is effective in preventing, detecting, and correcting material
misstatements that may occur in the accounting process, the auditor may
perform less substantive tests. Conversely, if the internal control is not
reliable, the auditor will have to perform extensive substantive tests. Thus,
the result of tests of control is a major factor in determining the nature,
timing and extent of the auditor’s substantive tests.

When auditing financial statements, auditors would ordinarily perform

test of control simultaneously with the test of details of transactions in
order to increase efficiency in the application of audit tests. This is called
dual-purpose testing.

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 AUDIT EVIDENCE

The auditor should obtain sufficient appropriate evidence to be able to

draw reasonable conclusions on which to base the audit opinion.

Evidence refers to the information obtained by the auditor in arriving

at the conclusions on which the audit opinion is based.

Audit evidence consists of underlying accounting data and

corroborating information.

 Underlying accounting data refers to the accounting records

underlying the financial statements. These include books of
accounts, related accounting manuals, worksheet supporting cost
allocations and reconciliations prepared by the client personnel.

 Corroborating information supporting the underlying accounting

data obtained from client and other sources. This includes
documents such as invoices, bank statements, purchase orders,
contracts, checks and other information obtained or developed by
the auditor through confirmation, recalculation, observation and
reconciliation.

Accounting data alone can not be considered sufficient evidence to

support an opinion on the financial statements. Accordingly, the auditor
must obtain corroborative information to support his audit report.

Qualities of evidence

Audit evidence is typically obtained as a result of

performing tests of control and substantive tests. In cases
where controls cannot be relied upon, evidence may be
obtained entirely from substantive tests. When obtaining
audit evidence from either tests of control or substantive

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tests, the auditor should consider the sufficiency and
appropriateness of audit evidence obtained.

When performing tests of control, audit evidence must

support the assessed level of control risk. When
performing substantive tests, audit evidence must support
the acceptable level of detection risk. At the conclusion of
the audit, the auditor should evaluate whether the
sufficiency and appropriateness of evidence from
substantive tests and tests of control supports the
financial statement assertions.

Sufficiency refers to the amount of evidence that the auditor

should accumulate. Because of the cost/benefit consideration
the auditor does not examine all evidence available. The
auditor uses his judgment to determine the amount of evidence
needed to support an opinion on the financial statements. The
following factors may be considered in evaluating the
sufficiency of evidence:

 The competence of evidence

The amount of evidence that is sufficient in a given

situation varies inversely with the competence of
evidence. Thus, the more competent the evidence, the
less amount of evidence is needed to support the
auditor’s opinion.

 The materiality of the item being examined.

The more material the financial statement amount

being examined, the more evidence will be needed to
support its validity. Conversely, if the account is not
material to the financial statements, the auditor does

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 not have to perform any procedure related to that
account.

 The risk involved in a particular account.

As the risk of misstatement in a particular account

increases, the more evidence will be needed.

 Experience gained during previous audit may indicate the

amount of evidence taken before and whether such
evidence was enough.

Appropriateness is the measure of the quality of audit

evidence and its relevance to a particular assertion and its
reliability.

Relevance relates the timeliness of evidence and its ability to

satisfy the audit objective. Reliability relates to the
objectivity of evidence and is influenced by its source and by
its nature.

While reliability of audit evidence is dependent on individual

circumstance, the following generalizations could help the
auditor in assessing the reliability of audit evidence:

 Audit evidence obtained from independent outside

sources (for example, confirmation received from a third
party) is more reliable than that generated internally.

 Audit evidence generated internally is more reliable when

the related accounting and internal control systems are
effective.

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  Audit evidence obtained directly by the auditor is more
reliable than that obtained from the entity.

 Audit evidence in the form of documents and written

representations is more reliable than oral representations.

Cost/benefit consideration when obtaining evidence

An auditor works within economic limits. The auditor’s opinion

to be economically useful must be formed within a reasonable
period of time and based on evidence obtained at a reasonable
cost. As a guiding rule, there should be a rational relationship
between the cost of obtaining evidence and the usefulness of the
information obtained. The auditor uses his professional judgment
in determining the appropriate type of evidence that should be
obtained.

Audit evidence does not have to be conclusive to be useful.

Ordinarily, the auditor finds it necessary to rely on audit evidence
that is persuasive rather than conclusive in nature and will often
seek audit evidence from different sources or of a different nature
to support the same assertion.

AUDIT DOCUMENTATION/ WORKING PAPERS

The sufficient appropriate evidence required by the professional

standards must be clearly documented in the auditor’s working papers.
Working papers are records kept by the auditor that documents the
audit procedures applied, information obtained and conclusions
reached. PSA 230 requires the auditor to document matters that are
important to support an opinion on financial statements, and evidence
that the audit was conducted in accordance with PSA.

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Functions of the working papers

Working papers are prepared primarily to

 Support the auditor’s opinion on financial statements.

 Support the auditor’s representation as to compliance with

PSA.
 Assist the auditor in the planning, performance, review and
supervision of the engagement.

Secondarily, working papers also assist the auditor in

 planning future audits.
 providing information useful in rendering other services (MAS
or tax consultancy)
 providing adequate defense in case of litigation.

Form, Content and Extent of Audit Documentation

It is neither necessary nor practicable to document every matter

the auditor considers during the audit. In deciding on the form,
content and extent of audit documentation, the auditor should
consider what would enable an experienced auditor, having no
previous connection with the audit, to understand:

(a) The nature, timing, and extend of the audit procedures

performed to comply with PSAs and applicable legal and
regulatory requirements;
(b) The results of the audit procedures and the audit evidence
obtained; and
(c) Significant matters arising during the audit and the
conclusions reached thereon.

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The form, content and extent of audit documentation depend on
factors such as:
 The nature of the audit procedures to be performed;
 The identified risks of material misstatement;
 The extent of judgment required in performing the work and
evaluating the results;
 The significance of the audit evidence obtained;
 The nature and extent of exceptions identified;
 The need to document a conclusion or the basis for a
conclusion not readily determinable from the documentation
of the work performed or audit evidence obtained; and
 The audit methodology and tool used.

Although audit documentation depends upon the auditor’s

judgment, the following important items would normally require
audit documentation:

 Discussions of significant matters with management and

others on a timely basis.

 In exceptional circumstances, when the auditor judges it

necessary to depart from a basic principle or an essential
procedure that is relevant in the circumstances of the audit,
the auditor should document how the alternative audit
procedures performed achieve the objective of the audit, and,
unless otherwise clear, the reasons for the departure.

 In documenting the nature, timing and extent of audit

procedures performed, the auditor should record:
(a) Who performed the audit work and the date such work was
completed; and
(b) Who reviewed the audit work performed and the date and
extent of such review

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Classification of working papers

In a continuing engagement, working papers are typically

classified into permanent file or current working paper file:

Φ Permanent file contains information of continuing

significance to the auditor in performing recurring audits. This
file would most likely include
 copies of the articles of incorporation and by-laws
 major contracts
 engagement letter
 organizational chart
 analyses of long-term accounts such as plant assets, long-
term liabilities and stockholders’ accounts.
 internal control analyses.

Current file contains evidence gathered and conclusions

reached relevant to the audit of a particular year. This file
would normally include

 a copy of the financial statements

 audit program
 working trial balance
 lead schedules
 detailed schedules
 correspondence with other parties such as lawyers,
customers, banks, and management.

Ownership of working papers

Working papers are the property of the auditor and the client
has no right to the working papers prepared by the auditor.
Working papers may sometimes serve as a reference source for

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the client (at the discretion of the auditor) but they should not be
considered as part or as a substitute for the client’s records.

Confidentiality of working papers

Although the working papers are the personal property of the

auditor, these working papers can not be shown to third parties
without the client’s permission. Section 4 of the Philippine Code
of Professional Ethics requires the CPA to respect the
confidentiality of information obtained during the course of
performing professional services. However, in some instances the
duty of confidentiality is overridden by the statue of law. For
example, the auditor can disclose confidential information to third
parties even without the client’s consent under the following
circumstances:

 When disclosure is required by law or when the

working papers are subpoenaed by a court.
 When there is a professional right to disclose
information such as when the auditor uses his working
papers to defend himself when sued by the client for
negligence.

Retention of working papers

Working papers should be retained by the auditor for a period of

time sufficient to meet the needs of his practice and to satisfy any
pertinent legal requirements of record retention.

Guidelines for the preparation of working papers

Working papers should be properly organized to facilitate their

review. The following techniques may be used by the auditor when
preparing working papers.

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  Heading
Each working paper must be properly identified with such
information as the name of the client, type of working paper, a
description of its content, and the date or period covered by
the examination.

 Indexing
Indexing refers to the use of lettering or numbering system
(for example “A” for Cash lead schedule). Each working
paper must be indexed to aid in cross-referencing essential
information.

 Cross-indexing/ cross referencing

Cross-referencing is important to provide a trail useful to
supervisors in reviewing the working papers.

 Tick marks
Working papers must include symbols that describe the audit
procedures performed.

AUDITING ACCOUNTING ESTIMATES

As defined by PSA 540, ‘accounting estimates’ means an

approximation of the amounts of an item in the absence of a precise
means of measurement. Accounting estimates are often made in
conditions of uncertainty regarding the outcome of events that have
occurred or are likely to occur and involve the use of judgment.
Examples include:

 Allowance for uncollectible accounts

 Depreciation and amortization
 Accrued revenue
 Deferred taxes
 Loss contingencies

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 Percentage of completion income on construction contracts
 Warranty claims

The auditor must be specifically careful in considering accounts that

are affected by accounting estimates because the risk of material
misstatement is greater when accounting estimates are involved.

Auditor’s Responsibility

Management is responsible for making accounting estimates

included in the financial statements. The auditor’s responsibility is to
obtain sufficient appropriate evidence as to whether
 Accounting estimate is properly accounted for and
disclosed; and
 Accounting estimate is reasonable in the circumstances.

Determining whether accounting estimates are properly accounted

for and disclosed requires knowledge of the client’s business and
application of relevant financial reporting standards. When
evaluating the reasonableness of accounting estimates, the auditor
should obtain an understanding of the procedures and methods,
including the accounting and internal control systems, used by
management in making the accounting estimates. In addition, the
auditor may use one or a combination of the following approaches:

1. Review and test the process used by management to

develop the estimate. This will often involve:
 evaluating data and management assumptions,
 testing of calculations,
 comparing prior periods estimates with actual
results, and
 considering management approval procedures.

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2. Make an independent estimate

The auditor may make or obtain an independent estimate and

compare it with the accounting estimate prepared by management.

3. Review subsequent events which confirm the estimate made.

Transactions and events which occur after period end, but

prior to completion of the audit, may provide sufficient
appropriate evidence regarding an accounting estimate made
by management.

After performing the above procedures, the auditor should

make a final assessment of the reasonableness of the estimate
based on the auditor’s knowledge of the business and whether
the estimate is consistent with other audit evidence obtained
during the audit.

RELATED PARTIES

The term related party refers to persons or entities that may have
dealings with one another in which one party has the ability to
exercise significant influence or control over the other party in
making financial and operating decisions. This would include entity’s
parent, subsidiaries, associates, affiliates, principal owners, directors,
officers including their immediate families.
While the existence of related parties and transactions between such
parties are considered ordinary features of business, the auditor needs
to be aware of them because:
 Generally accepted accounting principles in the Philippines
require disclosure in the financial statements of certain related
party relationships and transactions.

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 A related party transaction may be motivated by other than
ordinary business considerations such as profit sharing or even
fraud.
 The existence of related parties or related party transactions may
affect the financial statements and the reliability of audit
evidence.
Management’s responsibility

Management is responsible for the identification and disclosure of

related parties and transactions with such parties. This responsibility
requires management to implement adequate accounting and internal
control systems to ensure that transactions with related parties are
appropriately identified in the accounting records and disclosed in the
financial statements.

Auditor’s responsibility

The auditor should obtain and review information provided by the

directors and management identifying the names of all known related
parties and related party transactions. The following procedures may
assist the auditor in identifying related parties:

 Review prior-year working papers for names of known related

parties.
 Review the entity’s procedures for identification of related
parties.
 Inquire as to the affiliation of the directors and officers with other
entities.
 Review shareholder records to determine the names of principal
shareholders or, if appropriate, obtain a listing of shareholders
from share register.
 Review minutes of the meetings of shareholders and the board of
directors and other relevant statutory records such as the register
of director’s interests.

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 Inquire of other auditors currently involved in the audit, or
predecessor auditors, as to their knowledge of additional related
parties.
 Review the entity’s income tax returns and other information
supplied to regulatory agencies.

The above procedures may be modified as appropriate if in the

auditor’s judgment the risk of significant related parties remaining
undetected is low.

During the course of the audit, the auditor may perform the following
procedures to be able to identify related party transactions:

 Performing detailed tests of transactions and balances.

 Reviewing minutes of meetings of shareholders and
directors.
 Reviewing accounting records for large or unusual
transactions or balances, paying particular attention to
transactions recognized at or near the end of the reporting
period.
 Reviewing confirmations of loans receivable and payable
and confirmations from banks to identify the existence of
guarantee and other related party transactions.
 Reviewing investment transactions like purchase or sale
of an equity interest in a joint venture or other entity.

An audit can not be expected to provide assurance that all related

party transactions will be discovered. Nevertheless, the auditor
should be alert for unusual transactions that may indicate the
existence of related parties or related party transactions. Examples of
conditions in which related party transactions are likely would
include:

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 Transactions which have abnormal terms of trade, such as
unusual prices, interest rates, guarantees and repayment
terms.
 Transactions which lack an apparent logical business
reason for their occurrence.
 Transactions in which substance differs from form.
 Transactions not processed in an unbiased manner.
 High volume or significant transactions with certain
customers or suppliers as compared with others.
 Unrecorded transactions such as the receipt or provision
of management services at no charge.

When related party transactions are identified, the auditor should

obtain sufficient appropriate evidence that these are properly
accounted for and disclosed in the financial statements. The
auditor should also obtain a written representation from
management concerning the completeness of information
provided regarding the identification of related parties and the
adequacy of related party disclosures in the financial statements.

USING THE WORK OF AN AUDITOR’S EXPERT

The auditor’s education and experience enable the auditor to be

knowledgeable about business matters in general. However, the
auditor is not expected to have the expertise required to practice other
profession or occupation. During the audit, the auditor may need to
obtain audit evidence in the form of reports, opinions, valuations, and
statements of an expert. An expert is a person or firm possessing
special skill, knowledge and experience in a particular field other than
accounting auditing. Common examples of expert’s work include:

 Valuation of precious stones, works of arts, real estate, and other

specialized assets.

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 Determination of amounts using specialized techniques like
actuarial computations.

 Interpretation of technical requirements, regulations, or contracts

such as legal documents or legal title to property.

PSA 620 identifies two kinds of experts, namely:

 Auditor’s Experts
An expert, whose work in his/her field of specialization, is used
by the auditor to assist the auditor in obtaining sufficient
appropriate audit evidence.
 Management’s Expert
An expert, whose work in his/her field of expertise, is used by the
entity to assist the entity in preparing the financial statements.

Determining the need for an Auditor’s Expert

Not all engagements would require the help of an expert. Usually,

the auditor will be able to obtain sufficient appropriate evidence
about an account balance or transaction class even without the
help of an expert. In some instances however, the auditor can not
obtain satisfaction about an assertion without seeking the
assistance of an expert. When determining the need to use the
work of an expert, the auditor would consider:
 Whether management has used a management’s expert in
preparing the financial statements.
 The nature and significance of matter, including its
complexity.
 The risks of material misstatement in the matter.
 The expected nature of procedures to respond to identified
risks, including the auditor’s knowledge of and experience
with the work of experts in relation to such matters; and
the availability of alternative sources of audit evidence.

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Evaluating the Auditor’s Expert

After concluding that the help of the auditor’s expert is needed to

assist the auditor in obtaining sufficient appropriate evidence, the
auditor must:

1. Assess the competence and objectivity of the expert.

The following factors must be considered when assessing the

competence of the expert:

 Professional certification or licensing by, or membership

in, an appropriate professional body; and

 Experience and reputation in the field in which the auditor

is seeking audit evidence.

The evaluation of expert’s objectivity shall include inquiry

regarding interests and relationships that may create a threat to
the expert’s objectivity.

2. Understand the field of the expertise of auditor’s expert.

This understanding should enable the auditor to determine the
nature, scope and objectives of that expert’s work; and
evaluate the adequacy of that work for the auditor’s purposes.

3. Establish the terms of the agreement with the expert.

The auditor and the expert should agree on matters such as the
nature, scope, and objectives of the expert’s work; their duties
and responsibilities; timing of completion; and the need for
the auditor’s expert to observe confidentiality requirements. If
appropriate, such agreement has to be in writing.

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4. Evaluate the results of the work of the expert.
The auditor should assess the appropriateness of the expert’s
work as audit evidence regarding the financial statement
assertion being considered. This would require consideration
of the expert’s source of data, assumptions and methods, and
the results of expert’s work in light of the auditor’s knowledge
of the client’s business and the results of the other audit
procedures.

Ordinarily, the auditor’s expert work should enable the auditor

to satisfy his objectives. If the auditor determines that the
work of the auditor’s expert is not adequate for the auditor’s
purpose, the auditor should agree with the expert on the nature
and extent of additional work to be performed; or the auditor
may perform further audit procedures appropriate in the
circumstances.

Effect of the Reliance on Expert’s Work on the Audit Report

The auditor has sole responsibility for the audit opinion

expressed, and that responsibility is not reduced by the auditor’s
use of the work of an expert. Thus, the auditor should not refer to
the work of an auditor’s expert in an auditor’s report containing
an unmodified opinion.

When an auditor’s report contains a modified opinion, the

auditor can make reference to the expert’s work if the auditor
believes that such reference is necessary in order for the readers to
understand the reason for expressing a modified opinion. When
this happens, the auditor should indicate in his report that such
reference does not reduce the auditor’s responsibility for that
opinion.

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CONSIDERING THE WORK OF INTERNAL AUDITORS

Internal auditing is an appraisal activity established within an entity

as a service to the entity. The external auditor should obtain a
sufficient understanding of the internal audit activities to assist in
planning the audit and developing an effective audit approach. An
effective internal auditing will often affect the nature timing and
extent of the external auditor’s procedures. Considering the work of
internal auditor involves two important phases:

1. Making a preliminary assessment of internal auditing; and

2. Evaluating and testing the work of internal auditing.

Preliminary assessment of internal auditing

When planning the audit, the external auditor should make a

preliminary assessment of the internal audit function when it
appears that internal auditing is relevant to the external audit of
the financial statements in specific audit areas. For this purpose,
the external auditor should consider the internal auditor’s:

1. Competence
Consider the professional qualifications and experience
of the internal auditors.

2. Objectivity
Consider the organizational level to which the internal
auditors report the results of their work.

3. Due professional care

Consider proper planning, supervision and documentation of
internal auditor’s work.

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4. Scope of function
Consider the nature and extent of the internal auditors’
assignment.

Evaluating and testing the work of internal auditors

If based on the foregoing assessment, the external auditor decides

to use the work of the internal auditor, the external auditor will
have to evaluate and test the internal auditor’s work to confirm
its adequacy for the external auditor’s purposes. This evaluation
may include considering whether the work is performed by
competent persons; sufficient appropriate evidence is obtained;
appropriate conclusions are reached; and exceptions are properly
resolved.

Aside from using the work performed by the internal

auditors, the external auditor may also request the
assistance of the internal auditors in performing routine or
mechanical audit procedures. This is an acceptable
practice provided the external auditor supervises and
reviews the work performed by the internal auditors.

It is important to recognize that all judgments relating to the audit

of financial statements are those of the external auditor. The
auditor’s responsibility for audit opinion is not reduced by any use
made of internal auditing. Accordingly, the auditor’s report on
financial statements should not include any reference to the work
performed by internal auditors.

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