CHAPTER 8- PERFORMING SUBSTANSIVE TEST

1. Purpose of Substantive Tests

 Performed after considering inherent risk and control risk to reduce detection risk to an acceptably
low level.
 Designed to substantiate account balances or detect material misstatements in the financial
statements.
 Two types: Tests of Details/ Substantive Analytical Procedures

2. Substantive Analytical Procedures

 Used in planning, testing, and overall review stages.
 Provide corroborative evidence about assertions.
 Involve comparing financial information with auditor’s expectations to assess reasonableness.

Key Points:
 If significant fluctuations are found → investigate further (management inquiry + corroboration).
 Tolerance for differences depends on materiality and desired assurance level.
Suitability Factors:
 Nature of assertions.
 Reliability & precision of data/expectations.
 Predictability of account balances.
General Rules of Predictability:
 Income statement accounts = more predictable than balance sheet accounts.
 Non-discretionary accounts (e.g., payroll) = more predictable than discretionary ones (e.g.,
advertising).
 Stable environments = more predictable than dynamic ones.
3. Tests of Details : Examines actual account details.
Two approaches:
 Balances: direct testing of ending balances (e.g., cash count, bank reconciliation).
 Transactions: testing transactions that build balances.
When to Use:
 Test of Balances → many small, immaterial transactions (e.g., cash, A/R, inventory).
 Test of Transactions → few large, material transactions (e.g., PPE, bonds payable, equity).
4. Effectiveness of Substantive Tests Effectiveness depends on Nature, Timing, Extent:
 Nature: Quality of evidence (higher quality = higher cost).
 Timing: Can be at interim or year-end.
 Interim = less effective but spreads workload.
 Year-end = more reliable if high risk.
 Extent: Amount of evidence needed. Increases with higher assessed risk or materiality.

5. Relationship Between Substantive Tests & Tests of Control

 Test of Controls: Provides evidence on whether misstatements are likely to occur.
 Substantive Tests: Provides evidence whether misstatements exist.
Interaction:
 Effective controls → fewer substantive tests needed.
 Weak controls → more extensive substantive tests required.
 Dual-purpose test: One procedure serving both control testing & substantive testing (e.g.,
examining invoice approval & transaction validity).

6. Audit Evidence
Definition: Information obtained by the auditor to form a basis for the audit opinion.
Components:
 Underlying accounting data – books of accounts, manuals, reconciliations, etc.
 Corroborating information – invoices, bank statements, contracts, confirmations, recalculations,
observations.
Note: Accounting data alone is not sufficient; corroborative info is needed.
Qualities of Evidence
 Sufficiency: Quantity of evidence.
 Influenced by → competence of evidence, materiality of item, and risk of misstatement.
 Appropriateness: Quality of evidence (relevance + reliability).
 Relevance → ability to meet audit objective. Reliability → depends on source and nature.
Reliability Guidelines: External > internal. Direct auditor evidence > indirect. Written > oral.
Effective internal controls → higher reliability of internal evidence.
Cost/Benefit Consideration
 Evidence should be obtained at a reasonable cost and time. Audit evidence is usually persuasive,
not conclusive.

7. Audit Documentation / Working Papers

Definition: Records kept by the auditor that document audit procedures, evidence, and [Link]
230.
Purpose:
 Primary: Support opinion, show compliance with PSA, assist in planning/performance/review.
 Secondary: Assist in future audits, provide info for other services, defend in litigation.
Form, Content, and Extent
Should allow an experienced auditor with no prior involvement to understand:
 Nature, timing, and extent of procedures.
 Results and evidence obtained.
 Significant matters and conclusions.
Factors affecting documentation: nature of procedures, risks, level of judgment, significance of evidence,
audit methodology/tools.
Normally documented: discussions with management, departures from standards (with justification), who
performed/reviewed work (with dates).

8. Classification of Working Papers

Permanent File: info of continuing significance (e.g., incorporation papers, major contracts, engagement
letters, organizational chart, long-term accounts, control analyses).
Current File: current year evidence and conclusions (e.g., FS copy, audit program, trial balance, schedules,
correspondence).
9. Ownership, Confidentiality, Retention
 Ownership: Working papers belong to the auditor (not the client).
 Confidentiality: Cannot be shown to third parties without client’s consent, except when:
Required by law / subpoenaed by court. Auditor defends against a negligence claim.
 Retention: Should be retained long enough to meet practice needs and legal requirements.

10. Guidelines for Preparation of Working Papers

 Heading: Identify client, type, content, and period.
 Indexing: Numbering/lettering system (e.g., “A” for Cash).
 Cross-referencing: Provides review trail.
 Tick marks: Symbols showing audit procedures performed.

11. Attendance at Physical Inventory Count (PSA 501)

 Required if inventory is material. Auditor must: Inspect existence & condition. Perform test counts.
 Before/After year-end: Perform additional procedures to cover intervening period.
 Impracticable attendance: Perform alternative procedures (e.g., inspect subsequent sales).
 Failure to obtain evidence: → Qualified opinion or Disclaimer (PSA 705).
 Inventory held by third parties: Obtain confirmation and/or inspect documents (delivery receipts,
reports).

12. Auditing Accounting Estimates (PSA 540)

Definition: Approximation in absence of precise measurement (e.g., allowance for credit losses, warranty,
depreciation, contingencies, fair value). Higher risk of misstatement due to subjectivity/judgment.
Auditor’s Responsibility:
 Ensure estimates are properly accounted for and disclosed. Assess reasonableness in circumstances.
Evaluation Focus:
 Significant assumptions. Sensitivity to change. Deviations from history. Susceptibility to bias.
Audit Approaches:
1. Review/test management’s process (data, assumptions, calc, prior results).
2. Make independent estimate.
3. Review subsequent events.
4. For fair value estimates: Check methods, assumptions, and market data consistency with reporting
framework.

13. Related Parties (PSA 550)

Definition: Parties with control, significant influence, or common control. Includes family, key management,
or affiliated entities.
Risks:
Transactions may not be arm’s length. Possible fraud/misstatement. Required disclosures in FS.
Management’s Responsibility: Identify and disclose related parties/transactions.
Auditor’s Responsibility:
 Understand related party relationships & transactions.
 Assess risk of misstatement.
 Remain alert for unusual terms, abnormal pricing, substance vs. form issues.
Audit Steps:
1. Inquire management about related parties.
2. Inspect documents for evidence of such transactions.
3. Obtain understanding of business rationale.
4. Verify authorization & approval.
5. Obtain written representations from management re: completeness and disclosure.

14. Using the Work of an Expert (PSA 620)

Reason: Auditor not expected to be an expert in all fields (e.g., valuation of art, actuarial calculations, legal
opinions).
Types of Experts:
 Auditor’s Expert: Assists auditor (internal or external to firm).
 Management’s Expert: Assists management in preparing FS.
Auditor’s Responsibility:
 Evaluate expert’s competence, capability, and objectivity.
 Evaluate adequacy and relevance of expert’s work as audit evidence.

15. Management’s Expert (PSA 500)

Definition: Specialist (other than accounting/auditing) engaged by management to assist in preparing FS
(e.g., actuaries, appraisers, engineers).
Auditor’s Responsibilities:
 Evaluate competence, capabilities & objectivity of the expert.
 Obtain an understanding of the expert’s field (nature, scope, objectives).
 Evaluate appropriateness of expert’s work as audit evidence (relevance, reliability, assumptions,
methods).

16. Auditor’s Expert (PSA 620)

When Needed: If auditor cannot obtain sufficient evidence without specialist input.
Factors Considered in Decision:
 Whether management already used an expert.
 Nature, complexity, and significance of matter.
 Risk of material misstatement.
 Auditor’s own knowledge/experience with the matter.
 Availability of alternative evidence.
Evaluation of Auditor’s Expert:
1. Assess competence & objectivity (certifications, reputation, independence).
2. Understand the field to judge adequacy of work.
3. Agree on terms – scope, objectives, duties, confidentiality.
4. Evaluate results – data, assumptions, methods, and conclusions must align with auditor’s
knowledge and other evidence.

17. Effect of Reliance on Expert’s Work

 Auditor remains solely responsible for audit opinion.
 No reference to expert in an unmodified opinion.
 May reference in a modified opinion if needed for clarity (but responsibility still rests with auditor).

18. Considering the Work of Internal Auditors

Internal Audit Function: Assurance/consulting activity to improve governance, risk management, and
controls. External auditor evaluates if work can be used to reduce extent of own testing.
(A) Preliminary Assessment
 Competence – qualifications, training, experience.
 Objectivity – independence from management, reporting to audit committee.
 Due Professional Care – systematic, disciplined approach; documented procedures and quality control.
(B) Evaluating & Testing Internal Auditor’s Work
Check competence of persons performing the work.
Ensure sufficient evidence, appropriate conclusions, proper resolution of issues.
External auditor must:
 Read internal audit reports related to audit.
 Perform audit procedures to confirm adequacy of internal work.
 Extent of reliance depends on: judgment involved, risk of misstatement, competence & objectivity of
internal auditors.
(C) Assistance in Routine Work
Internal auditors may help in mechanical/routine procedures if supervised and reviewed by external auditor.
Responsibility for audit opinion remains with external auditor → no reference to internal auditors in the
audit report.
 CHAPTER 9 – AUDIT SAMPLING
1. Concept and Purpose
 Audit sampling: Applying audit procedures to less than 100% of a population so that all items have a
chance of selection (PSA 530).
 Used when it’s impractical to test every item; auditors draw conclusions about the population based on a
sample.
 Assumption: The sample is representative of the population.
 Sometimes, auditors perform:
 100% examination – all items tested (few, large items)
 Selective testing – only significant items tested

2. Risks in Sampling
A. Sampling Risk
Risk that the auditor’s conclusion based on the sample differs from that if the entire population was tested.
α (Alpha) Risk / Risk of Incorrect Rejection / Underreliance
Conclude control is ineffective or misstatement exists when it’s actually effective or no misstatement
exists.
Affects audit efficiency (more work than necessary).
β (Beta) Risk / Risk of Incorrect Acceptance / Overreliance
Conclude control is effective or no misstatement exists when it actually is not.
Affects audit effectiveness (failure to detect misstatements).
B. Non-sampling Risk
Risk of wrong conclusions due to human errors, such as:
Using inappropriate procedures
Failing to detect errors
Misinterpreting evidence
Control of Risks:
Sampling risk ↓ by: increasing sample size and using proper selection method
Non-sampling risk ↓ by: proper planning, direction, supervision, and review

3. Approaches to Audit Sampling

Approach Description Key Points
Statistical Uses random selection & Quantifies sampling risk, designs efficient sample,
Sampling probability theory measures sufficiency objectively
Non-statistical
Based on auditor’s judgment Simpler but subjective; cannot measure sampling risk
Sampling
Both are acceptable; differ only in ability to quantify risk.

4. Types of Audit Sampling Plans

Attribute Sampling – estimates frequency of a characteristic (e.g., deviation rate); used in tests of
controls.
Variable Sampling – estimates a peso value or misstatement amount; used in substantive tests.

5. Basic Steps in Audit Sampling

1. Define the Objective – what the test aims to prove.
2. Determine Audit Procedure – define the population & characteristic to test.
3. Determine Sample Size – based on risk level, tolerable rate, and expectations.
4. Select the Sample – choose method ensuring all items have a chance of selection.
5. Apply Procedures – perform audit test on sample
6. Evaluate Result –analyze whether sample supports audit objective.
Difference between audit sampling and 100% examination: steps 3, 4, and 6 (sampling size, selection,
and projection).
6. Sampling for Tests of Controls
Factors Affecting Sample Size
Factor Relationship with Sample Size Explanation
Acceptable Sampling Risk ↓ Risk → ↑ Sample Size Lower risk tolerance → larger sample
↓ Tolerable Rate → ↑ Sample Smaller acceptable error → more items
Tolerable Deviation Rate
Size tested
↑ Expected Rate → ↑ Sample
Expected Deviation Rate Anticipated more errors → larger sample
Size
If expected deviation rate > tolerable rate → control not tested; control risk assessed as high.

7. Sample Selection Methods

Random Number Selection – equal chance for each item (objective, unbiased).
Systematic Selection – uses fixed interval (easy to apply; ensure no population pattern).
Haphazard Selection – unstructured selection (non-statistical only).
Special cases:
Voided document – replace with another sample.
Missing document – count as deviation.

8. Evaluation of Results
Compute Sample Deviation Rate

Example: 4 deviations / 200 = 2%

Compare to Tolerable Deviation Rate

If Sample > Tolerable → control unreliable → increase substantive testing.
If Sample < Tolerable, consider allowance for sampling risk:
If difference is large (e.g., 2% vs. 10%) → control reliable.
If small (e.g., 8% vs. 10%) → risk high; control may not be reliable.
In statistical sampling, compute maximum population deviation rate = sample deviation rate + allowance
for sampling risk.

9. Summary Table
Concept Key Point
Audit Sampling Testing less than 100% of items to draw conclusions
Sampling Risk Wrong conclusion due to unrepresentative sample
Alpha Risk Underreliance / Incorrect rejection
Beta Risk Overreliance / Incorrect acceptance
Non-sampling Risk Human error, poor procedures
Sampling risk ↓ with larger, random sample; Non-sampling ↓ by
Control of Risk
planning/supervision
Statistical Sampling Uses probability; measures risk
Non-statistical Sampling Judgment-based
Attribute Sampling Tests of control (rate of deviation)
Variable Sampling Substantive test (amount of misstatement)
Key Factors for Sample
Acceptable risk, tolerable rate, expected rate
Size
Selection Methods Random, Systematic, Haphazard
Evaluation Compare sample vs. tolerable deviation rate
Other Sampling Applications for Tests of Controls
1. Sequential Sampling (Stop-or-Go Sampling)
Used when few deviations are expected.
No fixed sample size.
Auditor decides after each test whether to:
Stop (if no or few deviations – control is reliable), or
Go on (if some deviations – continue testing).
Efficient because it avoids unnecessary testing.

2. Discovery Sampling
Used when no deviations are expected, but one deviation is critical (e.g., fraud or irregularity
suspected).
Sample size is large enough to detect at least one deviation if it exists.

Sampling for Substantive Tests

Substantive tests deal with amounts and balances in financial statements.
Factors Affecting Sample Size
Acceptable Sampling Risk – Inversely related.
Lower risk → larger sample.
Based on detection risk (component of audit risk).
Tolerable Misstatement – Inversely related.
Maximum error allowed without affecting fairness of financial statements.
Expected Misstatement – Directly related.
More expected errors → larger sample.
Variation in the Population – Directly related.
Greater variability → larger sample.
Measured by standard deviation (for statistical sampling).

Sample Selection Methods (Substantive Tests)

1. Stratified Sampling
Population divided into groups (strata) with similar characteristics.
Reduces variability and sample size, focusing on higher-value items.
Example:
Above ₱1,000,000 → 100% examined
₱100,000–₱1,000,000 → 50 samples
Below ₱100,000 → 100 samples
2. Value-Weighted (Monetary Unit) Sampling
Each peso = one sampling unit.
Larger balances have higher probability of being selected.
Best for detecting overstatements.
Also called Probability-Proportional-to-Size (PPS) Sampling.

Evaluating Substantive Test Results

1. Project Misstatements to the Population
Two methods:

Ratio Estimation uses peso values.

Difference Estimation uses number of items (e.g., customers).
2. Compare Projected Misstatement with Tolerable Misstatement
If projected > tolerable, auditor must
Expand sample, Perform alternative procedures, or Ask client to adjust account.

If projected < tolerable, consider sampling risk (especially if amounts are close).
Anomalous Errors
Isolated, non-recurring errors → excluded from projection but still considered in overall
assessment.

Summary of Audit Sampling Steps

Step Tests of Controls Substantive Tests
1. Define
Specify control to test Specify purpose and related assertion
Objective
2. Determine Identify control procedure and
Identify account or transaction and population
Procedure population
Factors: Acceptable sampling risk (↓), Factors: Acceptable sampling risk (↓), Tolerable
3. Determine
Tolerable deviation rate (↓), Expected misstatement (↓), Expected misstatement &
Sample Size
deviation rate (↑) population variation (↑)
Random, Systematic, or Haphazard Random, Systematic, Haphazard (non-
4. Select Sample
(non-statistical) statistical), Value-weighted, or Stratified
5. Apply
Apply tests to sample items Apply audit procedures to sample items
Procedures
6. Evaluate Decide if account is fairly stated or needs
Decide if control can be relied upon
Results adjustment

Key Points to Remember

Statistical sampling: quantifies sampling risk; Non-statistical: uses judgment.
Sequential & discovery sampling: used for control testing.
Stratified & value-weighted sampling: used for substantive testing.
Sampling risk affects effectiveness, while non-sampling risk (human error) affects accuracy.
Main goal: obtain sufficient appropriate evidence at minimal cost and time.
 CHAPTER 12 – ASSURANCE ENGAGEMENT AND RELATED SERVICES

I. TYPES OF ENGAGEMENTS RELATED TO FINANCIAL STATEMENTS

Professional accountants may perform four types of services:
Audit/ Review/ Compilation/ Agreed-Upon Procedures
Each service differs in objective, level of assurance, and procedures performed.

II. AUDIT OF FINANCIAL STATEMENTS

Objective: To express an opinion on whether financial statements are fairly presented.
Level of Assurance : ✔ High (Reasonable Assurance) ✔ Provides positive assurance.
Procedures:
Risk assessment/ Tests of controls/ Substantive tests/ Detailed evidence-gathering

III. REVIEW OF FINANCIAL STATEMENTS

Usually for small entities that cannot afford a full audit.
Objective: To obtain limited assurance by: ✔ Inquiry ✔ Analytical procedures
Conclusion: “Nothing has come to our attention that the FS are not fairly presented…” This is negative
assurance.
Level of Assurance: ✔ Moderate / Limited Assurance ✔ Lower than an audit.
Key Review Procedures
Inquiries about significant items/ Analytical procedures/ Identify risks of material misstatement
Understand the entity + environment/ Consider related parties, fraud, going concern
When Problems Arise If misstatement/ Scope limitation is found:
Qualified conclusion – material but not pervasive Adverse conclusion – material + pervasive
Disclaimer – if scope limitation is severe

IV. COMPILATION OF FINANCIAL STATEMENTS

Used when clients need help preparing FS but do not want assurance.
Objective: To assist management in assembling financial information into financial statements.
Level of Assurance : ❌ No assurance The accountant uses accounting skills only, not auditing skills.
Key Points
Accountant does not verify accuracy/ No inquiries required/ Does not check internal controls
Does not express any conclusion/ FS are solely the responsibility of management
Report States clearly: ✔ What FS were compiled ✔ That no assurance is provided
If FS are materially misstated:
→ Accountant should propose corrections → If management refuses → Withdraw from engagement

V. AGREED-UPON PROCEDURES (AUP)

Objective: To perform specific procedures requested by the client or third-party users on certain accounts
or transactions.
Examples: A/P balance/ A/R aging/ Inventory count/ Related party purchases
Level of Assurance: ❌ No assurance Accountant only reports factual findings.
Key Characteristics
Client decides the nature, timing, and extent of procedures
Report is restricted to specified users
Independence not required, but if not independent, must be disclosed
Typical Procedures
Inquiry
Analysis
Recalculation
Observation
Inspection
Confirmation
VI. COMPARISON OF ENGAGEMENTS (SUPER SUMMARY)
Level of Type of
Engagement Objective Work Performed Standards
Assurance Assurance
Tests + evidence
Audit Opinion on FS fairness High Positive PSA
gathering
Limited assurance FS PSRE
Review Moderate Negative Inquiry + analytics
are plausible 2400
Assemble FS from
Compilation Assist in preparing FS None None PSRS
records
Agreed-Upon Perform procedures Specific audit-like
None None PSRS
Procedures requested steps

VII. MEMORY TIPS (SUPER QUICK)

Assurance Levels
Audit → High (Positive Assurance)
Review → Limited (Negative Assurance)
Compilation → No assurance
AUP → No assurance, only findings
Procedures
Audit → Full audit procedures
Review → Inquiry + analytics
Compilation → Assemble only, no checking
AUP → Only what is agreed
Control Responsibility
Audit/Review → Practitioner determines procedures
Compilation → Management gives info
AUP → Client chooses procedures