Category Archives for "Auditing"

test of controls
May 29

Test of Controls: When to Perform and How

By Charles Hall | Auditing

Most auditors don’t perform a test of controls? But should they? Below I explain when such a test is required. I also explain why some auditors choose to use this test even when not required. 

test of controls

Once risk assessment is complete, auditors have three further audit procedures they can use to respond to identified risks:

  1. Test of details 
  2. Substantive analytics
  3. Test of controls

This article focuses on the third option.

Below you will see:

  • The Right Response
  • Not Testing Controls (including video about the same)
  • The Decision Regarding Testing 
  • How to Test Controls
  • Required Tests
  • Which Controls to Test
  • Three-year Rotation of Testing
  • Interim or Period-End Testing

The Right Response 

Which responses to risks of material misstatement are best? That depends on what you discover in risk assessment.

If, for example, your client consistently fails to record payables, then assess control risk for completeness at high and perform a search for unrecorded liabilities (a substantive procedure).

By contrast, if the internal controls for receivables are strong, then assess control risk for the existence assertion at less than high, and test controls for effectiveness. (You do, however, have the option to perform substantive tests rather than test controls, even when controls are appropriate. More about this in a moment.)

Not Testing Controls

Many auditors assess control risk at high (after risk assessment is complete) and use a fully substantive approach. That is fine, especially in audits of smaller entities. Why? Because smaller entities tend to have weaker controls. As a result, controls may not be effective. Therefore, you may not be able to assess control risk at less than high. 

Control risk assessments of less than high must be supported with a test of controls to prove their effectiveness. But if controls are not effective, you must assess control risk at high. This is one reason why you might bypass testing controls: you know, either from prior experience or from current-year walkthroughs, that controls are not effective. If your test reveals ineffectiveness, you are back to square one: a control risk assessment of high. Then substantive procedures are your only option. In such a situation, the initial test was a waste of time. 

The Decision Regarding Testing 

But if controls are effective, why not test them? Doing so allows you to reduce your substantive procedures. There is one reason, however, why you might not test controls even though they appear appropriate: substantive tests may take less time.

Once risk assessment is complete, your responses—the further audit procedures—are based on efficiency and effectiveness. If control testing takes less time, then use this option. If substantive procedures takes less time, then perform a test of details or use substantive analytics. But, regardless of efficiency considerations, address all risks with appropriate responses.

How to Test Controls 

Suppose you’ve decided to test controls for effectiveness. But how? Let’s look at an example starting with risk assessment.

control test

Risk Assessment

Your approach to testing controls depends on risk. 

For example, suppose your billing and collections walkthrough reveals appropriate segregation of duties. You see that authorized personnel issue receipts for each payment received. Additionally, you determine that total daily cash inflows are reconciled by the collections supervisor to the online bank statement, and she signs off on a reconciliation sheet as evidence of this procedure. Lastly, you note that a person not involved in cash collections reconciles the monthly bank statement. In other words, controls are properly designed and in use. 

Furthermore, you believe completeness is a relevant assertion. Why? Theft of incoming cash is a concern since the business handles a high volume of customer checks. If checks are stolen, cash collections would not be complete. Consequently, the inherent risk for completeness is high. The fraud risk is a significant risk which requires a test of details in addition to the test of controls.

Test Supports Effectiveness

Now it’s time to test for effectiveness. 

Test the receipt controls on a sample basis. But before doing so, document the controls you desire to test and the sample size determinations. (See AICPA’s Audit Sampling standard, AU-C 530.)

The first control you are testing is the issuance of receipts by an authorized person and your sample size might be sixty. 

The second control you are testing is the daily reconciliation of cash to the bank statement. For example, you could agree total daily receipts to the bank statement for twenty-five days. As you do so, you review the daily sign-offs on the reconciliation sheets. Why? The collection supervisor’s sign-off is the evidence that the control was performed. 

The third control you are reviewing is the reconciliation of the bank account by a person not involved in the receipting process. So, you review the year-end bank reconciliation and confirm that the person that reconciled the bank statement was not involved in cash collections. 

Once the tests are performed, determine whether the controls are effective. If they are, assess control risk for the completeness assertion at less than high. Now you have support for that lower assessment. 

And what about substantive tests?

You need to perform a test of details since a significant risk (the fraud risk) is present. You might, for example, reconcile the daily total receipts to the general ledger for a month.

Test Doesn’t Support Effectiveness

If your tests do not support effectiveness, expand your sample size and examine additional receipts. Or skip the tests (if you believe the controls are not effective) and move to a fully substantive approach. Regardless, if controls are not effective, consider the need to communicate the control deficiency to management and those charged with governance. 

So, when should you test controls? First let’s look at required tests and then optional ones. 

Required Audit Tests of Controls

Here are two situations where you must test controls:

  • When there is a significant risk and you are placing reliance on controls related to that risk
  • When substantive procedures don’t properly address a risk of material misstatement

Let me explain.

Auditing standards allow a three-year rotation for control testing, as long as the area tested is not a significant risk. But if the auditor plans to rely on a test of controls related to a significant risk, operating effectiveness must be tested annually. 

Also a test of controls is necessary if substantive procedures don’t properly address a risk of material misstatement. For example, consider the controls related to reallocation of investments in a 401(k). The participant goes online and moves funds from one account to another. Other than the participant, there are no humans involved in the process. When processes are fully automated, substantive procedures may not provide sufficient audit evidence. If that is your situation, you must test of controls. Thankfully, a type 2 service organization control report is usually available in audits of 401(k)s. Such a report provides evidence that controls have already been tested by the service organization’s auditor. And you can place reliance upon those tests. In most cases, substantive procedures can properly address risks of material misstatement. So this test requirement is usually not relevant. 

Optional Audit Test of Controls

We just covered the two situations when testing is required. All other control testing is optional.

internal controls

Prior to making the decision about testing, consider the following:

  • Do you anticipate effectiveness? There’s no need to test an ineffective control. 
  • Does the control relate to an assertion for which you desire a lower control risk? 
  • Will it take less time to test the control than to perform a substantive procedure? Sometimes you may not know the answer to this question until you perform the test of controls. If the initial test does not prove effectiveness, then you have to expand your sample or just punt—in other words, use a fully substantive approach. 
  • Will you use the control testing in conjunction with a test of details or substantive analytics? How would effective controls reduce these substantive tests? In other words, how much substantive testing time would you save if the control is effective?
  • Is the control evidence physical or electronic? For example, are the entity’s receipts in a physical receipt book or in a computer? It’s usually easier to test electronic evidence.
  • How large will your sample size be? Some controls occur once a month. Others, thousands of times in the period. The larger the population, the larger the sample. And, of course, the larger the sample size, the more time it will take to perform the test. 
  • Can you test the population as a whole without sampling? Data analytics software—in some instances—can be used to test the entire population. For example, if a purchase order is required for all payments above $5,000, it might be easy to compare all payments above the threshold to purchase orders, assuming the purchase orders are electronic. 

Three-Year Rotation of Testing

As I said earlier, audit standards allow a three-year rotation for testing. For example, if you test accounts payable controls in 2020, then you can wait until 2023 to test them again. In 2021 and 2022, you need to ensure that these controls have not changed. You also want to determine that those controls have continuing relevance in the current audit. How? See if the controls continue to address a risk of material misstatement. And as you perform your annual walkthroughs, inquire about changes, observe the controls, and inspect documents. Why? You want to know that everything is working as it was in 2020, when the initial test was performed. And, yes, you do need to perform those walkthroughs annually, if that is how you corroborate your understanding of controls.

In short, testing for effectiveness can, in most cases, occur every three years. But walkthroughs are necessary each year. If you tested sixty transactions for an appropriate purchase order in 2020, then you can wait until 2023 to do so again. But review of the purchase order process each year in your annual walkthroughs. 

So should you test controls at interim or after year-end?

Interim or Period-End Testing

Some auditors test controls after the period-end (after year-end in most cases). Others at interim. Which is best?

It depends.

interim audit test

Perform interim tests if this fits better in your work schedule. Here’s an example: You perform an interim test on November 1, 2021. Later, say in February 2022, consider whether controls have changed during the last two months of the year. See if the same people are performing those controls. And consider performing additional tests for the November 1 to December 31 period. Once done, determine if the controls are effective. 

Testing on an interim date is not always the answer. For example, if management is inclined to manipulate earnings near year-end, then interim tests may not be appropriate

If you choose to test after period-end, then do so for the full period being audited. Your sample should be representative of that timeframe.

So should you ever test controls at a point in time and not over a period of time? Yes, sometimes. For example, test inventory count controls at year-end only. Why? Well those controls are only relevant to the year-end count, a point in time. Most controls, however, are in use throughout the period you are auditing. Therefore, you need to test those controls over that period of time (e.g., year).

Conclusion

As I said above, many auditors tend to rely fully on substantive responses to the risks of material misstatement. But, in some cases, that may not be the best or wisest approach. If controls are designed well and functioning, why not test them? Especially if it takes less time than substantive procedures.

Finally, take a look at my two related articles regarding responses to the risk of material misstatement: (1) Test of Details: Substantive Procedures and (2) Substantive Analytical Procedures: Power Up.

Substantive Analytical Procedures
May 06

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. 

substantive analytical procedures

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. 

SOC Report
Apr 24

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?

SOC Report

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

Complementary user entity controls. These are the controls performed by users of a service organization’s services. These entity controls complement the service organization’s controls: both are necessary to ensure the process is safe and effective. For example, your client might perform the complementary control of reviewing payroll hours reported before providing those to an outside payroll service organization. 

Service auditor. The auditor that reports on controls at a service organization.

Service organization. An organization that provides services to user entities that impact the user entity’s financial reporting.

User auditor. The auditor that audits the financial statements of a user entity.

User entity. An entity that uses a service organization and its related SOC report. 

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?

When does the external auditor not need SOC reports or other information related to a service organization? Paragraph .05 of AU-C 402 answers that question as follows:
 
This section does not apply to services that are limited to processing an entity’s transactions that are specifically authorized by the entity, such as the processing of checking account transactions by a bank or the processing of securities transactions by a broker (that is, when the user entity retains responsibility for authorizing the transactions and maintaining the related accountability).
 
Additionally, complementary user entity controls may be strong enough to eliminate the need for information about the service organization’s controls.

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 controlsIf 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. 

audit planning
Apr 04

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. 

audit planning

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.

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.

audit planning

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. 

audit assertions
Mar 07

Audit Assertions in Financial Statement Audits

By Charles Hall | Auditing

In this article, I address audit assertions and why they are critical to the audit process. We'll look at assertion examples and how to you can leverage these in your audit plan. Do you desire to stop over auditing? Then read on. 

All businesses make assertions in their financial statements. For example, when a financial statement has a cash balance of $605,432, the business asserts that the cash exists. When the allowance for uncollectibles is $234,100, the entity asserts that the amount is properly valued. And when payables are shown at $58,980, the company asserts that the liability is complete

audit assertions

Reporting Frameworks

Of course assertions derive their meaning from the reporting framework. So before you consider assertions, make sure you know what the reporting framework is and the requirements therein. For example, the occurrence of $4 million in revenue means one thing under GAAP and quite another under the cash basis of accounting

What is a Relevant Assertion?

For an auditor, relevant assertions are those where a risk of material misstatement is reasonably possible. So, magnitude (is the risk related to a material amount?) and likelihood (is it reasonably possible?) are both considered. 

For cash, maybe you believe it could be stolen, so you are concerned about existence. Is the cash really there? Or with payables, you know the client has historically not recorded all invoices, so the recorded amount might not be complete. And the pension disclosure is possibly so complicated that you believe it may not be accurate. If you believe the risk of material misstatement is reasonably possible for these areas, then the assertions are relevant. 

Some auditors refer to auditing by assertions as an assertions audit. Regardless of the name, we need to know what the typical assertions are. 

Audit Assertions

Assertions include:

  • Existence or occurrence (E/O)
  • Completeness (C)
  • Accuracy, valuation, or allocation (A/V)
  • Rights and obligations (R/O)
  • Presentation, disclosure, and understandability (P/D)
  • Cutoff (CU)

Not all auditors use the same assertions. In other words, they might use assertions different from those listed above, or the auditor could list each assertion separately. Regardless, auditors need to make sure they address all possible areas of misstatement. 

Assertions as Scoping Tool

Think of assertions as a scoping tool that allows you to focus on the important. Not all assertions are relevant to all account balances or to all disclosures. Usually, one or more assertions are relevant to an account balance, but not all. For example, existence, rights, and cutoff might be relevant to cash, but not valuation (provided there is no foreign currency) or understandability. For the latter two, a reasonable possibility of material misstatement is not present.

As you consider the significant account balances, transaction areas, and disclosures, specify the relevant assertions. Why? So you can determine the risk of material misstatement for each and create responses. Here’s an example for accounts payable and expenses. 

AssertionInherent RiskControl RiskRisk of Material MisstatementResponse
E/OModerateHighModeratePerform substantive analytics comparing expenses to budget and prior year
CHighHighHighPerform search for unrecorded liabilities
CUModerate HighModerateSubstantive analytical comparison of the payable balance

Inherent Risk Support

Accounts payable is not complex and there are no new accounting standards related to it. There are no subjective judgments. Volume is moderate and directional risk is an understatement. Inherent risk is assessed at high for completeness (client has not fully recorded payables in prior years). Occurrence and cutoff have not been a problem areas in past years.

Inherent Risk as the Driver

Risk of material misstatement is the result of inherent risk and control risk. Auditors often assess control risk at high because they don’t plan to test for control effectiveness. If control risk is assessed at high, then inherent risk becomes the driver of the risk of material misstatement. In the table above, the auditor believes there is a reasonable possibility that a material misstatement might occur for occurrence, completeness, and cutoff. So responses are planned for each. 

Fraud risks and subjective estimates can be (and usually are) assessed at the upper end of the spectrum of inherent risk. They are, therefore, significant risks. When a significant risk is present, the auditor should perform procedures beyond his or her normal approach. As we previously said, when the client’s risk increases, the level of testing increases. 

Significant Risk 

The payables/expenses assessment below incorporates an additional response due to a significant risk, the risk that fictitious vendors might exist.

AssertionInherent RiskControl RiskRisk of Material MisstatementResponse
E/OHighHighHighPerform substantive analytics comparing expenses to budget and prior year; Perform fictitious vendor test
CHighHighHighPerform search for unrecorded liabilities
CUModerate HighModerateSubstantive analytical comparison of the payable balance

Inherent Risk Support

Accounts payable is not complex and there are no new accounting standards related to it. There are no subjective judgments. The company suffered a fictitious vendor fraud during the year, so the occurrence assertion has uncertainty. Volume is moderate and directional risk is an understatement. Inherent risk is assessed at high for occurrence (significant risk) and completeness. Cutoff has not been a problem in past years. 

Significant Risk Example

In auditing expenses, the auditor knows that a risk of fictitious vendors exists. In this scheme the payables clerk adds and makes payments to a nonexistent vendor. Additionally, the payments are usually supported with fake invoices. What is the result? Yes, additional expenses. Those fraudulent payments appear as expenses in the income statement. So the occurrence assertion is suspect. 

If the auditor believes the risk of fictitious vendors is at the upper end of the inherent risk spectrum, then a significant risk is present in relation to the occurrence assertion. And such a risk deserves a fraud detection procedure. In this example, the auditor responds by adding a substantive test for detection of fictitious vendors. More risk, more work.  

Additionally, notice the inherent risk for occurrence is assessed at high. Why? Because it’s at the upper end of the inherent risk spectrum. A significant risk is, by definition, a high inherent risk, never low or moderate.

As you can tell, I am suggesting that risk be assessed at the assertion level. But is it ever acceptable to assess risk at the transaction level

Assessing Risk at the Transaction Level

Is it okay to assess audit risk in the following manner?

AssertionInherent RiskControl RiskRisk of Material Misstatement
E/O; CU; R/O; A/V; P/DHighHighHigh

Yes, but if all assertions are assessed at high, then a response is necessary for each. 

Those who assess risk at the transaction level think they are saving time. But is this a more efficient approach? Or might it be more economical to do so at the assertion level?

Assess the Risk of Material Misstatement at the Assertion Level

If the goal of assessing risk is to quickly complete a risk assessment document (and nothing else), then assessing risk at the transaction level makes sense. But the purpose of risk assessment is to provide planning direction. Therefore, we need to assess risk at the assertion level. 

Why? Let’s answer that question with an accounts payable example. 

Accounts Payable Risk Assessment Example

Suppose the auditor assesses risk at the transaction level, assessing all accounts payable assertions at high. What does this mean? It means the auditor should perform substantive procedures to respond to the high-risk assessments for each assertion. Why? The risk assessment for valuation, existence, rights and obligations, completeness, and all other assertions are high. Logically, the substantive procedures must now address all of these (high) risks.

Alternatively, what if the accounts payable completeness assertion is assessed at high and all other assertions are at low to moderate? How does this impact the audit plan? Now the auditor plans and performs a search for unrecorded liabilities. Additionally, he may not, for example, perform existence-related procedures such as sending vendor confirmations. The lower risk assertions require less work.

Do you see the advantage? Rather than using an inefficient approach—let’s audit everything—the auditor pinpoints audit procedures. 

Once assertions are assessed, it’s time to link them to further audit procedures.

Linkage with Further Audit Procedures

As a peer reviewer, firms say to me, “I know I over-audit, but I don’t know how to lessen my work.” And then they say, “How can I reduce my time without reducing quality?” 

Here’s my answer: Perform real risk assessments and document the risk of material misstatement at the assertion level. Then tailor—yes, change the audit program—to address the risks. Perform substantive procedures or a test of controls for effectiveness related to the identified risk areas—and slap yourself every time you even think about same as last year. (Your substantive procedures can be a test of details or substantive analytics.)

And what are the benefits of assessing risk at the assertion level?

  • Efficient work
  • Higher profits 
  • Conformity with standards

You may be wondering if financial statement level risk can affect assertion level assessments. Let's see. 

Risks at the Financial Statement Level

Financial statements have financial statement level risks such as management override or the intentional overstatement of revenues. These sometimes affect assertion level risk. For example, the intentional overstatement of revenues has a direct effect upon the existence assertion for receivables and the occurrence assertion for revenues. Therefore, even when you identify financial statement level risks, consider whether they might affect assertion level risks as well. 

Now let's talk about homework based on this article. Let's make this useful. 

Your Audit Assertion Documentation

Look at two or three of your audit files and review your risk assessments. Are you assessing risk at the transaction level or at the assertion level? Plan to spend more time in performing risk assessment procedures and documenting your risks at the assertion level—and possibly less time performing further audit procedures.

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