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Substantive Analytical Procedures: Power Up

By Charles Hall | Auditing

Are you using substantive analytical procedures in your audits? Many auditors rely solely on tests of details when a better option is available. Substantive analytics, in some cases, provide better evidential matter. And they are often more efficient than tests of details.

In this article, I provide:

• Substantive Analytics – A Video Overview
• Analytics in Three Stages
• Substantive Analytics
• Responses to Risk of Material Misstatement
• Substantive Analytical Assurance Level
• Examples of Substantive Analytics
• Documenting Substantive Analytical Procedures
• Other Substantive Analytical Considerations

Professional standards define analytical procedures as evaluations of financial and non-financial data with plausible relationships. An example of such a relationship is salaries may be expected to be a certain percent of total expenses. In other words, numbers behave in particular ways. Because they do, we can use these relationships as evidential matter for our audit opinions.

Substantive Analytics – A Video Overview

This video provides an overview of substantive analytical procedures. 

Before we look at what substantive analytics are and how we use them, let’s see how analytical procedures are used in audits.

Analytics in Three Stages

Auditors use analytics in three stages:

1. Preliminary (risk assessment)
2. Final (wrap up)
3. Substantive (response to risk of misstatement)

Preliminary analytics are performed as a risk assessment procedure. We use them to locate potential material misstatements. And if we identify unexpected activity, we plan a response. For example, if we expect payroll to go up 5% but it goes down 8%, then we plan further audit procedures to see why: these can include tests of details, substantive analytics, and test of controls. 

At the completion of the audit, we use final analytics to determine if we have addressed all risks of material misstatement. Here we compare our numbers and ask, “Have we dealt with all risks of material misstatement?” If yes, fine. If not, then we may need to perform additional further audit procedures. 

Less precision is necessary for preliminary and final analytics as compared to substantive analytics. Preliminary analytics locate misstatements and final analytics confirm the results of the audit. But substantive analytics are used to prove material misstatements are not present. 

Substantive Analytics

Substantive analytical procedures can, in certain cases, be more effective and efficient than a test of details. 

For example, if the ratio of salaries to total expenses has been in the 46% to 48% range for the last few years, then you can use this ratio as a substantive analytic to prove the payroll occurrence assertion. If your expectation is that payroll would be in this range and your computation yields 48%, then your substantive analytic provides evidence that salaries occurred. And this is much easier than a test of details such as a test of forty payroll transactions (where you might agree hours paid to time records and payroll rates to authorized amounts). 

Disaggregation of Data

For a small entity with six employees, one payroll substantive analytic might be sufficient, but you may need to disaggregate the payroll information for a larger company with six hundred people. For instance, you might divide departmental salaries by total salaries and compare those ratios to the prior year. Disaggregation adds more precision to the analytic, resulting in better evidential matter. 

Another example of disaggregation is in relation to revenues. If the company has four major sources of revenue, disaggregate the substantive analytical revenue sources. You might use a trend analysis by revenue source for the last three years. Or you might recompute an estimate of one or more revenue sources based of units sold or property rented. 

The type of substantive analytic is dependent on the nature of the transaction or account balance. If a company rents fifty apartments at the same monthly rate, computing an estimate of revenue is easy. But if a company sells fifty different products at different prices, you may need to disaggregate the substantive analytical data. 

Additionally, consider disaggregating substantive analytics by region if the company has different geographic locations. 

Not for Significant Risk Areas (at least not alone)

Are there audit areas where substantive analytical procedures should not be used alone? Yes. When responding to a significant risk. A test of details must be used when a significant risk is present. For example, a bank’s allowance for loan losses. This allowance is a highly complex estimate; therefore, a test of details is required. You could not solely compare the allowance to prior years,  for example, though such a comparison could complement a test of details. In other words, you could perform a test of details and use a substantive analytic. But a substantive analytic alone would not do. 

Now let’s consider how auditors use substantive analytics to respond to the risk of material misstatement.

Responses to Risks of Material Misstatement

Once you identify a risk of material misstatement, you plan further audit procedures including (1) test of details, (2) substantive analytical procedures, and (3) test of controls. Many auditors use a test of details without performing substantive analytics. Why? For many, it’s habit. We’ve always tested bank reconciliations, for example, so we continue to do so. But maybe we’ve never used substantive analytics to prove revenues or expenses. 

A test of details is often used in relation to balance sheet accounts such as cash, receivables, and debt. 

Substantive Analytical Procedures as a Response

Substantive analytics, on the other hand, are sometimes more fitting for income statement accounts such as revenue or expenses. Why? Because income statement accounts tend to be more consistent from year to year. Here are some examples:

• Depreciation expense
• Payroll expense
• Lease revenue
• Property tax revenue (in a government)

So consider using substantive analytics when the volume of transactions is high and the account balance is predictable over time. Additionally, use substantive analytics in lower risk areas, including some balance sheet accounts such as: 

• Plant, property, and equipment (if no significant additions or retirements)
• Debt (if no new debt or early payoffs)
• Prepaid assets (e.g., prepaid insurance)

Audit standards tell us that substantive analytics are more appropriate when the risk of misstatement is lower. The higher the risk of misstatement, the more you should use a test of details. For instance, it’s better to use tests of details for significant receivable accounts. But substantive analytics may work well for prepaid insurance. 

Additionally, substantive analytics can be combined with a test of details or a test of controls. If, for example, you’re planning a risk response for accounts payable and expenses, you might use a combined approach: a test of details for accounts payable (e.g., search for unrecorded liabilities) and substantive analytics for expense (e.g., departmental expenses divided by total expenses compared to the prior year).

Another common combined approach is a test of details sample along with substantive analytics. If the substantive analytics are effective, you can reduce the sample size, making the overall approach more efficient. 

Substantive Analytical Assurance Level

Certain substantive analytics provide higher levels of assurance. For example, computing expected rental income provides high assurrance. If your client rents fifty identical apartments at $2,000 a month, the computation is easy and the assurance is high. 

How to Increase Assurance When Using Substantive Analytics

Other types of analytics provide lower assurance: topside ratios or period-to-period comparisons at the financial statement level, as examples. You can, however, increase the substantive analytical assurance level by taking actions such as:

• Using more comparative periods (e.g., years or months)
• Comparing ratios to independently published industry statistics 
• Disaggregating the data (e.g., revenues by product line and units sold)
• Documenting expectations prior to creating the analytics (to remove bias)
• Documenting client responses regarding differences along with the follow up procedures and results

Comparing balances with a prior period and providing no explanations is not sufficient as a substantive analytic. Also, if the activity is unexpected, solely documenting client responses to questions is not sufficient. For example, these client answers will not do:

• Client expected revenues to go up
• Numbers declined because sales activity went down
• Client said it’s reasonable

Vague responses are not evidential matter and can result in audit failure, or—worse yet—litigation against your firm. 

Substantive analytics can be used in a wide variety of ways. 

Examples of Substantive Analytics

Here are examples of substantive analytics:

• Comparison of monthly sales for the current year with that of the preceding year (to test occurrence)
• Comparison of profit margins for the last few months of the audit period with those subsequent to period-end (to test cutoff)
• Percent of expenses to sales compared with the prior year (to test occurrence)
• Current ratio compared to prior year (to test for solvency and going concern)
• Comparing current year profit margins with prior periods (to test accuracy and occurrence)
• For pension or postemployment benefit plans: actuarial value of plan assets divided by actuarial accrued liability compared to prior year (to test completeness and accuracy)
• For debt: total debt divided by total assets compared to prior year (to test the financial strength of the entity and going concern)
• For inventory: cost of goods sold divided by average inventory compared to prior year (to test existence and occurrence)

Now let’s see how to document your substantive analytics.

Documenting Substantive Analytical Procedures

In performing substantive analytical procedures, document the following:

1. The reliability of the data 

Document why you believe the data is trustworthy. Reasons could include your prior experience with the client’s accounting system and internal controls related to the information you are using. Though a walkthrough sheds light on those controls, a test of controls for effectiveness provides even greater support for the reliability of the data. Testing controls is optional, however. 

2. Assessed risk of material misstatement by assertion 

Document the assertions being addressed and the related risks of material misstatement. 

3. Expectation 

Document a sufficiently precise expected result of the computation or comparison. You can use a range. Document the expectation prior to examining the recorded numbers. Why? To reduce bias. If the current year expectation is different from the prior year, explain why. For example, if payroll has been stable over the last three years but is expected to increase eight percent in the current year, document why. A less precise expectation may be acceptable if a test of details is performed along with the substantive analytic. 

4. Approach 

Document if the substantive analytic is to be used alone or in conjunction with a test of details. 

5. Acceptable difference 

The acceptable difference is the amount that requires no further investigation. So, for example, if the analytic is $30,000 different from the recorded amount and the acceptable difference is $50,000, you are done. No additional work is necessary. Unacceptable differences require further investigation such as inquiries of management and other audit procedures. Consider the performance materiality for the transaction or account balance as you develop the acceptable difference amount. Also, consider the assessed risk of material misstatement. Higher risk requires a lower acceptable difference. 

6. Conclusion 

Document whether the computation or comparison falls within your expectation. Perform and document other procedures performed if the result is not within your acceptable difference. Your conclusion should include a statement regarding whether you believe the account or transaction balance is materially correct. After all, that’s the purpose of the substantive analytic. 

Here are some concluding thoughts about substantive analytics. 

Other Substantive Analytical Considerations

Substantive analytics are not required. So, think of them as an efficient alternative to test of details.

If the company has weak internal controls or a history of significant misstatements, rely more on tests of details. Substantive analytics work better in stable environments. Additionally, if you, as the auditor, expect to make several material audit adjustments, record those prior to creating substantive analytics. This will help reduce the distortion from those misstatements. 

Testing of controls for effectiveness lends strength to substantive analytics. If the controls are effective, you’ll have more confidence in the substantive analytics. For example, if you test the disbursement approval controls and find them to be effective, the expense analytics will be more trustworthy. If you are testing controls for effectiveness, you may want to do so before creating any related substantive analytics. 

You may also want to see AU-C 520, Analytical Procedures in the audit standards. 

Emphasis of Matter & Other Matter Paragraphs: SAS 134

By Charles Hall | Accounting and Auditing

When are SOC Reports Needed by an External Auditor?

By Charles Hall | Auditing

Service organization control (SOC) reports are often necessary to understand outsourced accounting services. So, what are SOC reports and when are they needed?

What are SOC Reports?

When an entity provides services to other entities (e.g., ADP payroll services), the service organization desires to provide comfort to their clients. Why? Well the service organization wants to provide assurance regarding the safety and effectiveness of its services. Trust is foundational to the business relationship. Therefore, the service organization provides comfort to clients by hiring an outside independent auditor to review its accounting system. The result of that review is a service organization control report. 

So if ADP desires to give comfort to its clients regarding the design and operation of its accounting system, it will hire an outside audit firm to review and render an opinion on its internal controls. While SOC reports provide comfort the service organization’s clients, they are also used in another manner. 

Suppose ADP provides payroll services to Jet Sports, Inc. The auditors of Jet Sports will review ADP’s SOC report to see if their accounting system is appropriately designed and operating. After all, ADP, in this example, is an extension of Jet Sports, Inc.’s accounting system. Jet’s auditors view ADP’s services as a part of Jet’s accounting system: Jet has simply outsourced their payroll services to ADP. That’s why ADP’s SOC report is relevant to Jet Sports, Inc.’s audit. 

When are SOC Reports Needed?

SOC reports are needed when:

• The user entity’s complementary controls are not sufficient to lessen the possibility of material misstatements
• The SOC report provides information concerning a significant transactions cycle

Many organizations outsource portions of their accounting to service organizations, such as ADP’s payroll services. External auditors need to understand a service organization’s system and related controls–particularly if that work could allow material misstatements in the user’s financial statements. This understanding is provided in SOC reports.

All financial statement audits focus upon whether material misstatements are occurring. Moreover, the auditor’s opinion is supported by audit evidence proving the financial statements are fairly stated. But does (some of this) audit evidence come from SOC reports? Sometimes, yes.

A financial statement auditor is concerned with material misstatements, regardless of how or where they occur, and regardless of who allows the misstatement. Therefore, auditors look for internal controls weaknesses in both the entity being audited and service organizations.

As we will see, the external auditor may not need all SOC reports. On the other hand, some SOC reports may be needed but don’t exist.

Definitions Related to Service Organizations

Before delving into the details of service organization controls, let’s define a few key words. 

Audit Standard for Service Organizations

AU-C 402, Audit Considerations Relating to an Entity Using a Service Organization, states the following:

Services provided by a service organization are relevant to the audit of a user entity’s financial statements when those services and the controls over them affect the user entity’s information system, including related business processes, relevant to financial reporting.

So if a service organization’s activities affect an entity’s information system, business processes, or financial reporting, then that activity is relevant. 

When is a SOC report not needed?

Complementary User Entity Controls

The user entity–an entity that uses a service organization and whose financial statements are being audited–may have controls sufficient to eliminate the need for SOC reports or other information from the service organization. Sometimes the user entity has controls that mitigate the risk of material misstatements caused by service organization deficiencies. Such controls are referred to as complementary user entity controls. If the complementary controls operate effectively, the user auditor–the auditor who audits and reports on the financial statements of a user entity–may not need SOC reports or other service organization information.

Alternatively, if the service organization initiates, executes, and does the processing and recording of the user entity’s transactions and the complementary controls would not detect material misstatements, then the user auditor may need SOC reports or other service organization information.

When complementary controls are present, they should be reviewed in the walkthrough of controls by the user auditor. For example, if your client reviews payroll time recorded prior to submission to an outside payroll service provider, then determine if this control is designed appropriately and implemented (as you do for all key controls). SOC reports usually provide a list of complementary controls, so look there for potential client controls. Then see if they are in use. 

Is the Placement of a SOC Report in the Audit File Sufficient?

Placing a SOC report in an audit file without reading and understanding it provides little-to-no audit evidence.

A SOC report provides information about how the service organization’s controls lessen the possibility of material misstatement. So, the user auditor needs to read and document how the service organization’s controls lessen the risk of material misstatement. This understanding of controls is necessary if the service organization’s work affects a significant transaction cycle such as payroll.

Think of SOC reports in this manner: Pretend there is no service organization and the company being audited performs the same processes and controls. If the audited entity performs these controls–and no service organization exists–the auditor gains an understanding of the controls using risk assessment procedures such as inquiry, observations, and inspections of documents. Potential control weaknesses are exposed by the risk assessment process. Thereafter, the identified risks are used to develop the audit program and substantive procedures. The same audit process is true when there is a service organization. But when a service organization is used, the user auditor is using the SOC report to gain the understanding of the service organization’s part of the entity’s accounting system.

If controls weaknesses are noted in the SOC report, the user auditor may–as a response–perform substantive procedures. By doing so the auditor lowers the overall audit risk (which is the risk that the auditor will issue an unmodified opinion when one is not merited).

Type 1 or Type 2 SOC Reports?

Service organization auditors can issue type 1 or type 2 reports.

A type 1 SOC report provides a description of a service organization’s system and the suitability of the design of controls.

A type 2 SOC report includes a service organization auditor’s opinion on the fairness of the presentation of management’s description of the service organization’s system and the suitability of the design and operating effectiveness of the controls.

The type 1 report provides information about the service organization’s system and related controls. The type 2 report provides an opinion on the system description and the design and effectiveness of the controls. A type 1 or a type 2 report can be used to gain an understanding of the controls.

You may see, in some of these SOC reports, carve-outs. 

Carve-Outs

Many SOC reports carve out services that are provided to the service organization by another service provider (a service provider to a service provider, if you will). In such a situation, consider whether you need to review the sub-service provider’s SOC report. (Sub-service providers are named in the SOC report along with what they do.)

So, should you (the user auditor) ever visit a service organization’s office?

Should the Auditor Visit the Service Organization?

Usually, the user auditor does not need to visit the service organization, but sometimes it is necessary to do so. If the service organization provides no SOC report and the complementary user controls are not sufficient, then the auditor may have no choice but to review the service organization’s system and controls. Only do so if the service organization handles significant parts of the accounting system.

SOC Reports Summary

In summary, if you audit an entity that uses a service organization, consider whether you need a SOC report. If the service organization provides services that impact a significant transaction cycle or account balance, then you probably need to review the related SOC report. Why? To see if there are any service organization internal control weaknesses that impact your client’s audit. 

Funded Depreciation: Becoming More Profitable

By Charles Hall | Accounting and Auditing , Local Governments

From time to time, I have clients ask me “What is funded depreciation?” And more importantly, they ask, “How can this technique make my organization more profitable and less stressful?”

Here’s a simple explanation.

Funded depreciation is the setting aside of cash in amounts equal to an organization’s annual depreciation. The purpose: to fund future purchases of capital assets with cash.

Funded Depreciation

Suppose you buy a $10,000 whiz-bang gizmo—a piece of equipment—that you expect to use for ten years, and at the end of the ten years you expect it to have no value. Your annual depreciation is $1,000.

In this example, a $1,000 depreciation expense is recognized annually on your income statement (depreciation decreases net income) even though no cash outlay occurs. The balance sheet includes the cost of the whiz-bang gizmo, but at the end of ten years, the equipment has a $0 book value, being fully depreciated.

The smart manager will annually set aside $1,000 in a safe investment—such as a certificate of deposit or money market account—for the future replacement of the whiz-bang gizmo.

If the company does not annually invest the $1,000, it has a few options at the end of the ten-year period:

• Borrow the full amount for the replacement cost
• Seek outside funding (e.g., grants)
• Use other funds from within the organization
• Lease the equipment
• Ask U2 to do a special benefits concert—just kidding

Obviously, if you borrow money to replace the equipment, you will have to pay interest—another cash outlay. Suppose the rate is 10%. Now the organization must pay out $1,100 each year. So, if the organization funds the depreciation (invests $1,000 annually), it earns interest. But if the entity chooses not to fund depreciation, it pays interest.

Businesses that fund depreciation are always making money from interest (granted not much these days) rather than paying for it.

Another advantage to funding depreciation: you know you will have the money to purchase the capital asset. You’re not concerned with whether a creditor will lend you the money for the acquisition. You’re financially stronger.

Why Doesn’t Every Entity Fund Depreciation?

So why doesn’t everyone fund depreciation?

• Some don’t understand the concept
• Some had rather spend the cash flows for the ten years (e.g., owners taking too much in distributions)
• Some need the money just to run the organization
• In governments, elected officials desire to keep tax rates low while they are in office
• In growing businesses, the owners may need the money to fund the growth of the company
• Most importantly, it may require two cash payments 

Concerning the last point, if the business had to borrow money to purchase the initial capital asset, then it must make debt service payments (cash outlay 1). If the company also funds depreciation for that same asset (making investments equal to the annual depreciation), another cash flow occurs (cash outlay 2). Nevertheless, if the business can ever get into a position where it pays cash for new equipment, it will be better off. Then only one cash outlay (investment funding) occurs, and the company is making–not paying–interest.

What if the organization cannot–due to cash flow constraints–fund depreciation for all new equipment purchases? Consider doing so for just one or two pieces of equipment–over time, the entity may be able to move into a fully funded position.

Who Should Fund Depreciation?

So, who should fund depreciation?

Organizations with sufficient cash flow and discipline. It’s the smart thing to do.

Imagine a world with no debt, a world where you don’t have to wonder how you will pay for equipment. Dreaming? Maybe, but funded depreciation is worth your consideration.

See my article Auditing Plant, Property, and Equipment. 

Audit Planning: Develop Your Audit Plan and Strategy

By Charles Hall | Auditing

This article teaches you how to develop your audit plan and strategy. Once you complete your risk assessment, it’s time to build these critical pieces of your audit engagement. 

Effectiveness and efficiently are both possible with a good audit plan. Below I explain how to do this. Additionally, we’ll also take a look at three common mistakes made in planning. See if you make any of these. 

To be in compliance with audit standards, we need to develop:

• Our audit strategy
• Our audit plan

Developing Your Audit Strategy

What’s in the audit strategy? AU-C 300, Planning an Audit, states that the audit strategy should include the following:

• The characteristics of the engagement (these define its scope)
• The reporting objectives (these affect the timing of the audit and the nature of the reports to be provided)
• The significant factors (these determine what the audit team will do)
• The results of preliminary engagement activities (these inform the auditor’s actions)
• Whether knowledge gained on other engagements is relevant (these potentially provide additional insight)

Think of the audit strategy as the big picture.

We are documenting:

• The scope (the boundaries of the work)
• The objectives (what the deliverables are) 
• The significant factors (e.g., is this a new or complex entity?)
• The risk assessment (what are the risk areas?)
• The planned resources (e.g., the engagement team) 

Much can be achieved with the right strategy—even walking on the moon.

Strategy for Walking on the Moon

When NASA planned to put a man on the moon, a strategy was created. It could have read as follows:

We will put a man on the moon. The significant factors of our mission include mathematical computations, gravitational pull, thrust, and mechanics. The risks include threats to our astronauts’ lives, so we need to provide sufficient food, air, sound communications, and a safe vessel. The deliverable will be the placement of one man on the moon and the safe return of our three astronauts. The engagement team will include three astronauts, launch personnel at Kennedy Space Center, and mission-control employees in Houston, Texas. 

A sound strategy led to Neil Armstrong’s historic walk on July 20, 1969.

Our audit strategy—in a more pedestrian pursuit—is a summary of objectives, resources, and risk. It’s the big picture. Our strategy leads to the successful issuance of our audit opinion (not quite as exciting as walking on the moon, but still important).

What’s in an Audit Strategy?

The audit strategy doesn’t have to be complicated or long, especially for smaller entities—it can be a short memo. What are we after? A summary of risks, needed resources, and objectives.

My firm uses an internally-developed strategy form—mainly, to ensure consistency. The form contains structure, such as references to risk assessment work and blank boxes in certain areas—such as partner directions—so it is flexible. As a result, the form has structure and flexibility.

Here are the main areas we cover:

• Deliverables and deadlines
• A time budget
• The audit team
• Key client contacts
• New accounting standards affecting the audit
• Problems encountered in the prior year 
• Anticipated challenges in the current year 
• Partner directions regarding key risk areas
• References to work papers addressing risk

Who Creates the Audit Strategy?

Who should create the strategy? The in-charge can create it with the assistance of the engagement partner, or the partner can do so. 

Audit Strategy as the Central Document

If you want to see one document that summarizes the entire audit, this is it. As you can see, the strategy is general in nature, but you also need a detailed plan to satisfy the demands of the strategy—this is the audit plan (commonly referred to as the audit program). NASA had a mission statement for Apollo 11, but—I’m sure—written guidelines directed the step-by-step execution of the project. 

Audit Plan (or Audit Program)

Now we create the detailed planning steps—the audit program. Think of the audit program as the final stage of audit planning. What have we done to get to this stage of the audit? 

1. Performed risk assessment procedures
2. Developed our audit strategy

Now it’s time to create the audit plan.

The audit plan is the linkage between planning and further audit procedures. What are “further audit procedures”? They are the tactical steps to address risk including substantive procedures and test of controls. The audit program links back to the identified risks and points forward to the substantive procedures and test of controls. Substantive procedures include tests of details and substantive analytical procedures.

Creating the Audit Program

How—in a practical sense—do we create the audit programs? Most auditors tailor the prior year audit programs. That works—as long as we revise them to address the current year risks. Audit programs are not—at least, they should not be—static documents. Even so, the current year audit program can be the same as last year—as long as the risks are the same.

Sufficient Audit Steps

How do we know if we have adequate audit program steps? Look at your risks of material misstatement (RMM)—which, hopefully, are assessed at the assertion level (e.g., completeness). Audit steps should address all high and moderate RMMs. 

Integrating Risk Assessment with the Audit Program

How else can we integrate our documentation? Put the relevant assertions next to each audit step—this makes the connections between the RMMs (at the assertion level) and the audit steps clear.

AU-C 330 says the auditor is required to apply substantive procedures to all relevant assertions related to each material class of transactions, account balance, and disclosure. So, the audit program should reflect steps for all material areas.

Creating Efficiency in the Audit Plan

Once you complete your risk assessment work, you want to ask, “Which is the more efficient route? Testing controls or performing substantive procedures.” Then go with your instincts. 

Generally, I assess control risk at high. While we can’t default to a high control, we can—once the risk assessment work is complete—decide to assess control risk at high as an efficiency measure. Why? If we assess control risk at below high, we must test the controls as a basis for the lower risk assessment. The testing of controls can—sometimes—take longer than substantive procedures. 

For example, is it better to test the controls related to fixed asset additions or is it more efficient to vouch the invoices for significant additions? Usually, the vouching of the invoices will get you to your desired destination quicker than testing controls. Generally—at least in my opinion—this line of reasoning is less true for more complex organizations. Larger organizations process more transactions and tend to have better controls. So it can be better to test controls for larger entities.

There you have it—the creation of the audit strategy and the audit plan. Your strategy includes the risks, needed resources, and objectives. And your audit program contains the tactical steps to address risks. You are set to go. 

I find that auditors usually understand the above, but still make one of the following three audit planning mistakes. 

Three Mistakes in Audit Planning

Auditors make three common planning mistakes: (1) not tailoring audit programs and (2) allowing prior year work papers to drive the audit process, and (3) using a balance sheet audit approach. Let’s see how these happen.

1. Not Tailoring Audit Programs

Where do most audit programs come from? They are purchased from forms providers, usually international publishing companies. These purchased programs are useful, but they can become a crutch, leading to canned audit approaches that are not responsive to risks. 

If we use unrevised audit programs and if our audit approach is always the same, what good is risk assessment? Another way to say this is, If audit programs never change, why perform walkthroughs, preliminary analytics, and other risk assessment procedures? 

Canned audit programs are one reason auditors give lip-service to risk assessment. In the auditor’s mind, he may be thinking, I already know what I’m going to do, so why waste time with risk assessment? This cookie-cutter approach is dangerous, but quite common. And why is it dangerous? Because it can lead to an intentional blindness toward internal controls and significant risks. And deficiencies in risk assessment lead to deficiencies in audit procedures. The result: material misstatements are not identified and an unmodified audit opinion is rendered. In other words, audit failure occurs.

Audit programs can be tailored: steps can be added, changed, or deleted. These steps can be amended based on the risk of material misstatement. But some auditors don’t change their audit plan. 

And not tailoring audit programs can lead to several problems such as:

• Audit team members signing off on steps not performed 
• Team members typing Not Applicable (N/A) next to several audit steps 
• Auditors performing unnecessary procedures 
• Auditors not performing necessary procedures 

In addition to not tailoring audit programs, some auditors hit autopilot and use their prior year work papers as their current year plan. 

2. Prior Year Work Papers as the Audit Plan

Audit documentation should develop sequentially:

1. Risk assessment
2. Audit programs
3. Audit work papers 

But poor auditors tend to follow the prior year work papers and complete the audit program as an afterthought. Worse yet, the risk assessment work is completed at the end of the engagement, if at all. The tail wags the dog. This same-as-last-year approach leads to incongruities in risks of material misstatement and the procedures performed. In effect, the prior year work papers become the current year audit program. 

Another common audit planning mistake is the use of a balance sheet audit approach. 

3. Balance Sheet Audit Approach

Many auditors use a fully substantive approach, meaning they don’t test controls for effectiveness. Moreover, some auditors test balance sheet accounts and little else. But this approach can lead to problems.

I have heard auditors say: If I audit all of the balance sheet accounts, then the only thing that can be wrong is the composition of revenues and expenses. But is this true?

The accounting equation says:

Totals assets = Total liabilities plus Total equity

Another way to say this is:

Total equity = Total assets minus Total liabilities

If we disregard stock purchases and sales, equity is usually the accumulation of retained earnings. And retained earnings comes from the earnings or losses on the income statement. In other words, retained earnings comes from revenues and expenses. So the net income or loss (revenues minus expenses) has to fit into the accounting equation (equity equals assets minus liabilities).

Therefore, if we audit all assets and liability accounts, doesn’t it make sense that the only thing that can be wrong is the composition of revenues and expenses? Mathematically I see why someone might say this, but a flaw lurks in the construct. 

Audit Failure Example

I once saw an audit firm sued for several million dollars. The CPAs audited the company for several years, issuing an unqualified opinion each year, but a theft was occurring all along.

So what were the audit firm’s mistakes? They relied too heavily upon a balance sheet audit approach, and they did not gain an understanding of the company’s key internal controls. 

The auditors used substantive procedures such as:

• Testing bank reconciliations
• Sending receivable confirmations and vouching subsequent collections
• Computing annual depreciation and agreeing it to the general ledger
• Vouching additions to plant, property, and equipment
• Performing a search for unrecorded liabilities in payables
• Confirming debt

The balance sheet accounts reconciled to the general ledger, and no problems were noted in the audit of the balance sheet accounts. But millions were missing. 

So what flaw lies in a balance sheet audit approach? Millions can go missing while the balance sheet accounts reconcile to the general ledger. Consequently, auditing the balance sheet accounts alone may not detect theft. Therefore, gaining an understanding of the internal controls and developing appropriate responses is critical to identifying material misstatements, especially when fraud is possible. 

So as we plan our substantive procedures, we need to avoid the flawed balance sheet approach. Yes, substantive procedures for the balance sheet accounts are important, but fraud detection procedures are necessary when control weaknesses are present. A test of details is necessary when a significant risk (such as a fraud risk) is present. 

In Summary

Develop an audit strategy and plan once you complete your risk assessments procedures. Then link the risks of material misstatement to your further audit procedures. Doing so will help ensure that your audit is successful. In other words, that no material misstatements are present when you issue an unmodified opinion. 

Moreover, don’t make these three audit planning mistakes: (1) not tailoring audit programs and (2) allowing prior year work papers to drive the audit process, and (3) using a balance sheet audit approach.

See my audit series The Why and How of Auditing to learn even more about the full audit process, including how to audit transaction cycles such as cash, receivables, payables, and debt.