CHAPTER

4 PHASE II – RISK RESPONSE:

DESIGNING OVERALL RESPONSES AND
FURTHER AUDIT PROCEDURES
4-1. The five types of tests auditors use to determine whether financial statements are
fairly stated includes the following:

 Procedures to gain an understanding of internal control

 Tests of controls
 Substantive tests of transactions
 Analytical procedures
 Tests of details of balances

While procedures to gain an understanding of internal control help the auditor

obtain information to make an initial assessment of control risk, tests of controls
must be performed as support of an assessment of control risk that is below
maximum. The purpose of tests of controls is to obtain evidence regarding the
effectiveness of controls which may allow the auditor to assess control risk below
maximum. If controls are found to be effective and functioning, the substantive
evidence may be reduced. Substantive evidence is obtained to reduce detection
risk. Substantive evidence includes evidence from substantive tests of
transactions, analytical procedures, and tests of details of balances.

4-2. Tests of controls are audit procedures to test the operating effectiveness of control
policies and procedures in support of a reduced assessed control risk. Specific
accounts affected by performing test of controls for the acquisition and payment
cycle include: cash, accounts payable, purchases, purchase returns and
allowances, purchase discounts, manufacturing expenses, selling expenses,
prepaid insurance, leasehold improvements, and various administrative expenses.

4-3. Tests of controls are audit procedures to test the operating effectiveness of control
policies and procedures in support of a reduced assessed control risk. Examples
include:

1. The examination of vendor invoices for indication that they have been
clerically tested, compared to a receiving report and purchase order, and
approved payment.
2. Examination of employee time cards for approval of overtime hours worked.
3. Examination of journal entries for proper approval.
4. Examination of approvals for the write-off of bad debts.
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Substantive tests of transactions are audit procedures testing for monetary

misstatements to determine whether the six transaction-related audit objectives
have been satisfied for class of transactions. Examples are:

1. Recalculation of amounts (quantity times unit selling price) on selected sales

invoices and tracing of amounts to the sales journal.
2. Examinations of vendor invoices in support of amounts recorded in the
acquisitions journal for purchases of inventories.
3. Recalculation of gross pay for selected entries in the payroll journal.
4. Tracing of selected customer cash receipts to the accounts receivable master
file, agreeing customer names and amounts.

4-4. The auditor resolves the problem by making assumptions about the results of the
tests of controls and performing both tests of controls and substantive tests of
transactions on the basis of these assumptions. Ordinarily the auditor assumes an
effective system of internal control with few or no exceptions planned. If the
results of the tests controls are as good as or better than the assumptions that were
originally made, the auditor can be satisfied with the substantive tests of
transactions, unless the substantive tests of transactions themselves indicate the
existence of misstatements. If the tests of controls results were not as good as the
auditor assumed in designing the original tests, expanded substantive tests must be
performed.

4-5. Substantive tests of transactions are performed to verify the accuracy of a client’s
accounting system. This is accomplished by determining whether individual
transactions are correctly recorded and summarized in the journals, master files,
and general ledger. Substantive tests of transactions are also concerned with
classes of transactions, such as payroll, acquisitions, or cash receipts. Tracing
amounts from a file of vouchers to the acquisitions journal is an example of a
substantive test of transactions for the acquisition and payment cycle. Tests of
details of balances verify the ending balance in an individual account (such as
inventory, accounts receivable, or depreciation expense) on the financial
statements. An example of a test of details of balances for the acquisition and
payment cycle is to physically examine a sample of the client’s fixed assets.

4-6. The audit of fixed asset additions normally involves the examination of invoices
in support of the additions and possibly the physical examination of the additions.
These procedures are normally performed on a test basis with a concentration on
the more significant additions. If the individual responsible for recording new
acquisitions is known to have inadequate training and limited experience in
accounting, the sample size for the audit procedures should be expanded to
include a larger sample of the additions for the year. In addition, inquiry as to
what additions were made during the year may be made by the auditor of plant
managers, the controller, or other operating personnel. The auditor should then
search the financial records to determine that these additions were recorded as
fixed assets.
 Phase II – Risk Response: Designing Overall Responses and Further Audit Procedures 4-3
Care should also be taken when the repairs and maintenance expense account is
analyzed since lack of training may cause some depreciable assets to be expensed
at the of acquisition.

4-7. Before reduced substantive testing is permitted, internal controls must be effective
and the auditor must have found the results of the tests of controls satisfactory.
Cost effectiveness of reduced assessed control risk should be considered in
making the decisions as to whether to test controls. The cost effectiveness of
reduced control risk is an audit efficiency issue.

4-8. It is desirable to design tests of details of balances before performing tests of

controls and substantive tests of transactions to enable the auditor to determine if
the overall planned evidence is the most efficient and effective in the
circumstances. In order to do this, the auditor must make assumptions about the
results of the tests of controls and substantive tests of transactions. Ordinarily the
auditor will assume no significant misstatements or control problems in tests of
controls and substantive tests of transactions unless there is reason to believe
otherwise. If the auditor determines that the tests of controls and substantive test
of transactions results are different from those expected, the amount of testing of
details of balances must be altered.

Exercise Answers

4-1.
AUDIT TRIAL TEST OF CONTROL
a. Yes Account for numbers included in the sequence to
determine that all documents are there.
b. Yes Examine a sample of bank reconciliation for
indication that the controller prepared each one.
c. No Observe whether the supervisor is present and
performing his responsibilities at the employees
check in.
d. Yes Examine invoices for controller’s approval.
e. No* Observe the cashier preparing the deposit slip and
delivering the deposit to the bank.
f. Yes Examine sales invoice for initials.
g. No* Observe president’s secretary opening mail and
prelisting cash receipts. Also examine existence of
prelisting.
*
The primary concern in these two items is the separation of duties rather than the
existence of the deposit slip and prelisting. The primary test of control produce must
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therefore be observation.
4-2.
a. The performance of interim tests of controls and substantive tests of transactions is
an effective means of keeping overtime to a minimum where many clients have the
same year-end date. However, this approach requires additional start-up time each
time the auditor enters the field to perform additional tests during different times of
the year. In the case of a small client, start up costs and training time may require
more total time than waiting until after December 31.
b. Cabrera may find that it is acceptable to perform no additional tests of controls and
substantive test of transactions work as a part of the year-end audit tests under the
following circumstances:
1. The results of the tests of the interim period indicate the accounting system is
reliable.
2. Inquiries concerning the remaining period may indicate there were no significant
changes in internal control and accounting procedures.
3. The transactions occurring between the completion of the tests of controls and
substantive tests of transactions and the end of the year are not unusual
compared to the transactions previously tested and to the normal operations of
the company.
4. Other tests performed at the end of the year do not indicate that the internal
controls are less effective than the auditor has currently assessed.
5. The remaining period is not too long in the circumstances. (Some consensus
exists in the profession requiring the remaining period to be three months or
less, depending upon the circumstances.)
6. Other matters of concern to the auditor indicate that the limitation of interim
testing is appropriate (i.e., risk of exposure to legal sanction is not too great; the
auditor will probably be familiar with the client’s operations and will determine
that a reduced control risk is justified; the auditor has appropriate confidence in
the competence of personnel and the integrity of management).
c. If Cabrera decides to perform no additional tests of controls and substantive tests of
transactions, depending upon the circumstances, she may wish to perform
analytical procedures, such as reviewing interim transactions for reasonableness or
tracing them to their source, comparing balances to previous period, or other such
procedures, for the remaining period to year-end.

4-3.
a. The sequence the auditor should follow is:
3. Assess control risk.
1. Determine whether it is cost effective to perform tests of controls.
 Phase II – Risk Response: Designing Overall Responses and Further Audit Procedures 4-5

4. Perform test of controls.

2. Perform substantive tests of details of balances.
The only logical sequence for parts b through e are shown as follows:

E E

A B D

G H
D

C D

a. Any other sequence is not cost effective or incorrect. For example, E, A,

G, C would be the sequence when there is planned reduced assessed
control risk and effective results of tests of controls.
b. The sequence is E, A, H, D. The logic was reasonable.
The auditor believed the internal controls would be effective and it
would be cost effective to perform tests of controls. In performing the tests
of controls the auditor concluded the controls were not effective.
Therefore, expanded substantive tests of details of balances were needed.
c. The sequence is E, B, G, C. The auditor concluded the internal controls
may be effective, but it was not cost effective to reduce assessed control
risk. The auditor should not have performed test of controls. It would have
been more cost effective to skip performing tests and instead follow the
sequence E, B, D.
d. The sequence if F, A, G, C. The logic is not reasonable. When the auditor
concluded the controls were not effective he or she should have gone
immediately to D and performed expanded substantive tests of details of
balances.
e. The sequence F, D. The logic was reasonable. The auditor concluded that
internal controls were not effective, therefore the auditor went directly to
substantive tests of details of balances and performed expanded tests.
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4-4.
a. Factors which could explain the difference in the amount of evidence accumulated in
different parts as well as the total time spent on the engagement are:
1. Internal control;
2. Materiality of the account balance;
3. Size of the populations;
4. Makeup of populations;
5. Initial vs. repeat engagement;
6. Results of the current and previous audits;
7. Existence of unusual transactions;
8. Motivation of the client to misstate the financial statements;
9. Degree of client integrity;
Reliance by third parties on the audited financial statements.

4-5.
a. For audit 1 the recommended strategy is to maximize the testing of internal of
controls and minimize the testing of the details of all ending balances in inventory.
The most important objective would be to minimize the number of locations that
need to be visited. The justification for doing this is the quality of the internal
controls and the results of prior year’s audits. Assuming that some of the locations
have a larger portion of the ending inventory balance than other locations, the
auditor can likely completely eliminate tests of physical counts of some locations
and emphasize the locations with larger dollar balances. The entire strategy is
oriented to minimizing the need to visit locations.
b. Audit risk for this audit should be low because of the plans to sell the business,
severe under-financing and a first year audit. The lack of controls over accounts
payable and the larger number of adjusting entries in accounts payable indicate the
auditor cannot consider the internal controls effective. Therefore the plan should be
to do extensive tests of details of balances, probably through accounts payable
confirmation and other end of year procedures. No tests of controls are
recommended because of the impracticality of reduced assessed control risk. Some
substantive tests of transactions and analytical procedures are recommended to
verify the correctness of acquisitions and to obtain information about the
reasonableness of the balances.

c. The most serious concern in this audit is the evaluation of the allowance for
uncollectible accounts. Given the adverse economic conditions, significant increase
of loans receivable, the auditor must be greatly concerned about the adequacy of
allowance for uncollectible accounts and the possibility of uncollectible accounts
being included in loans receivable. Given the internal controls, the auditor is not
 Phase II – Risk Response: Designing Overall Responses and Further Audit Procedures 4-7
likely to be greatly concerned about the gross accounts receivable balance, except for
accounts that need to be written off. Therefore, for the audit of gross accounts
receivable there will be a greatly reduced assessed control risk and relatively minor
confirmation of accounts receivable. In evaluating the allowance for uncollectible
accounts, the auditor should test the controls over granting loans and following up on
collections. However, given the changes in the economy, it will be necessary to do
significant additional testing of the allowance for uncollectible accounts. Therefore
an “S” is included for tests of details of balances for gross accounts receivable and
an “E” for the tests of net realizable value.

4-6.
a. The following is a time line for the audit procedures, showing the sequence of the
parts of a typical audit.
July Audit Report
31 Date

5, 9, 7, 2 8 1 3 4 6

Parts 5, 9, and 7 are all a part of planning and are therefore done early. As a part of
planning the audit, the auditor obtains an understanding of internal control and
initially assesses control risk. The auditor then performs tests of controls and
substantive tests of transactions and reassesses control risk.
Ideally, most analytical procedures are performed after the client has prepared
financial statements, but before tests of details of balances are performed. Therefore,
they should be done before confirmation of accounts payable to provide information
about expectation of misstatement.
Confirmation of accounts payable should be done as early as possible after the
statement of financial position to facilitate getting responses back, performing
alternative procedures for nonresponses, and reconciling differences before the audit
is completed.
Tests of review of subsequent events are normally the last procedures done on the
engagement before the audit report date. The audit report is issued after the audit
report date.
b. The time line shows that 5, 9, 7 and 2 are frequently done before the statement of
financial position.

Multiple Choice Answers

4-1. (b) 4-6. (c)

4-2. (d) 4-7. (a)
4-3. (a) 4-8. (d)
4-4. (c) 4-9. (c)
4-5. (b)
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