Tests of details, a substantive procedure, is the auditor's primary response to risks of material misstatement. Today I tell you what a test of details is and how you can best use this substantive approach..

Further Audit Procedures

AU-C 330: Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained defines substantive procedures as:

• Tests of details
• Substantive analytical procedures

Once you assess your risks of material misstatement you determine your responses. These further audit procedures (responses) include the two substantive procedures listed above as well as test of controls.

So of the three further audit procedures, are certain ones required?

Yes.

A test of controls is necessary if substantive procedures can’t properly address a risk of material misstatement. Think complex information technology processes. For example, when a benefit plan participant changes his investment options in a 401(k). There may be no physical documents to examine. In these circumstances, a test of controls might be your only option.

By contrast, auditors are required to perform tests of details when significant risks are identified. A test of controls alone will not do. So if, for example, you have determined that a complex estimate is a significant risk, then plan and perform a test of details in response. Likewise, if you believe a fraud risk is present, perform a test of details.

Additionally, substantive procedures are required for relevant assertions related to each material class of transactions, account balances, and disclosures. However, for this requirement, the auditor can use:

• Substantive analytics alone 
• A tests of details alone
• A combination of substantive analytics and test of details

This article focuses on tests of details. So, let’s move to that topic.

What is a Test of Details?

The video below explains test of details and comes from my YouTube playlist titled Audit Risk Assessment Made Easy. 

Audit standards don't define tests of details. They only say that a test of details is one of two substantive procedure options (the other being substantive analytics).

Test of Details Examples

Since there is no definition, here are examples of a test of details:

• Vouching invoices
• Tracing bills sent to customers
• Search for unrecorded liabilities in accounts payable
• Testing bank reconciliations by examining subsequent month bank statements
• Sending bank confirmations
• Sending customer confirmations
• Agreeing receivables to contracts
• Vouching subsequent receipts in receivables
• Reconciling payroll in the general ledger to quarterly payroll tax returns

As you can see, a test of details is just what it says it is. You are digging into the details of transactions. Substantive analytics, by contrast, look at numbers from a broader perspective. For example, the auditor might compute the current ratio or compare this year's debt level with prior years. I provided examples of substantive analytics in a recent article.

Now let's see how you can best select your tests of details procedures.

Tests of Details - Selection of Procedures

So, how do you determine which response is best? 

AU-C 330 tells us to pay attention to the nature of the risk. Doing so allows us to determine the what, when and how of our procedures. The audit standards refer to this as the nature, timing and extent. So, here is the way to design appropriate responses to your client’s risks of material misstatement. 

1. Nature of Evidence

First, let's discuss the type of procedures or, as the audit standards call it, the nature of evidence. If an auditor believes that receivables might be overstated, then she might send confirmations to customers. Why confirmations? To prove the existence of the receivables. And confirmations provide third party evidence which is better than that from within the company. Customers usually have no reason to respond in a dishonest manner, so the third party evidence is more reliable.

Prepaid assets, by contrast, usually has a low risk of material misstatement. They are not complex. The volume of transactions is low. They are not an estimate. So, in this instance, the auditor could use substantive analytics. Again, the nature of the risk drives your response.

Your responses are critical. If your tests don't address the risk of material misstatement, what good are they? 

In addition to the nature of evidence, timing matters as well.

2. Timing of Evidence

So, should you perform interim audit procedures? The answer depends on the reliability of the accounting system. Interim work is more easily done when you audit reliable systems. Consider waiting until period-end to audit unreliable systems. Why? If your interim work yields significant problems, you may not feel comfortable with roll-forward procedures. In other words, you may have to re-perform your interim work at period end. 

Do you perform a search for unrecorded liabilities? Then some time must pass from period-end before you do this procedure. The entity needs time to receive period-end invoices and make payments before you can review them. Likewise, if you are examining subsequent period receivable collections, some time must pass before you do so. Wait at least three or four weeks from period end before you perform these types of procedures.  

In addition to the nature and timing, the quantity of information is critical.

3. Extent of Evidence

The extent or quantity of evidence is another decision. Higher risks call for more evidence. If accounts payable has been materially understated the last two years, then consider lowering your search threshold for unrecorded liabilities. If you've used $10,000, you could, for example, move it to $3,000. The lower threshold will yield more evidence. The main point here is you want more evidential matter as risk increases.

But can you audit too much information? The answer is yes, unless you have an unlimited time budget. So, you want to examine enough information without overdoing it.

A question to ask in designing your quantity is, “Will this test allow me to detect a material misstatement?” For instance, you might plan a sample. But once you total the individually significant items, you see the remaining amount is immaterial. Then test the individually significant items and stop. 

Choosing Your Tests of Details

So there you are. A summary of nature, timing and extent as they relate tests of details. Learning to match your procedures with risks is one of the most important things you'll do as an auditor. Using canned audit programs or the same-as-last-year approach can lead to significant problems. Therefore, know your risks. Then design and perform responsive procedures.

Tests of Details by Account Balance

If you desire to see tests of details by account balances and transaction cycles, see The Why and How of Auditing series. There I provide you with tests of details for accounts such as cash, receivables and debt. 

Are you aware of the coming changes in accounting for equity securities with ASU 2016-01?

In the past, FASB required that changes in the fair value of available-for-sale equity investments be parked in accumulated other comprehensive income (an equity account) until realized--that is, until the equity investment was sold. In other words, the unrealized gains and losses of equity investments were not recognized in net income until the investments were sold. This is about to change.

Changes in equity investments will generally be reflected in net income as they occur--even before the equity investments are sold. 

The guidance for classifying and measuring investments in debt securities is unchanged.

Changes in Accounting for Equity Securities - ASU 2016-01

First, ASU 2016-01 removes the current guidance regarding classification of equity securities into different categories (i.e., trading or available-for-sale). 

Secondly, the new standard requires that equity investments  generally be measured at fair value with changes in fair value recognized in net income (see exceptions below). Companies will no longer recognize changes in the value of available-for-sale equity investments in other comprehensive income (as we have in the past).

Is the accounting for equity investments without readily determinable fair values different? It can be.

Equity Investments without Readily Determinable Fair Values

An entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment.  This election should be documented at the time of adoption (for existing securities) or at the time of purchase for securities acquired subsequent to the date of adoption. The alternative can be elected on an investment-by-investment basis.

Why make the election to measure equity investments that do not have readily determinable fair values at cost minus impairment? Because of the difficulty of determining the fair value of such investments. This election will probably be used by entities that previously carried investments at cost. 

ASU 2016-01 requires that equity investments without readily determinable fair values undergo a one-step qualitative assessment to identify impairment (similar to what we do with long-lived assets and goodwill). 

At each reporting period, an entity that holds an equity security shall make a qualitative assessment considering impairment indicators to evaluate whether the investment is impaired. Impairment indicators that an entity considers include, but are not limited to, the following:

• A significant deterioration in the earnings performance, credit rating, asset quality, or business prospects of the investee
• A significant adverse change in the regulatory, economic, or technological environment of the investee
• A significant adverse change in the general market condition of either the geographical area or the industry in which the investee operates
• A bona fide offer to purchase, an offer by the investee to sell, or a completed auction process for the same or similar investment for an amount less than the carrying amount of that investment
• Factors that raise significant concerns about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants.

So what happens if there is an impairment?

The FASB Codification (321-10-35-3) states the investment shall be written down to its fair value if a qualitative assessment indicates that the investment is impaired and the fair value of the investment is less than its carrying value.

How is the impairment reflected in the income statement?

If an equity security without a readily determinable fair value is impaired, the entity should include the impairment loss in net income equal to the difference between the fair value of the investment and its carrying amount.

Presentation of Financial Instruments

Entities are to present their financial assets and liabilities separately in the balance sheet or in the notes to the financial statements. This disaggregated information is to be presented by:

• Measurement category (i.e., cost, fair value-net income, and fair value-OCI
• Form of financial asset (i.e., securities or loans and receivables)

So, financial assets measured at fair value through net income are to be presented separately from assets measured at fair value through other comprehensive income.

Debt Securities Accounting 

U.S. GAAP for classification and measurement of debt securities remains the same. Show unrealized holding gains and losses on available-for-sale debt securities in other comprehensive income.

Disclosure Eliminated - Financial Instruments Measured at Amortized Cost

ASU 2016-01 removes a prior disclosure requirement. In the past, entities disclosed the fair value of financial instruments measured at amortized cost. Examples include notes receivables, notes payable, and debt securities. ASU 2016-01 removes this disclosure requirement for entities that are not public business entities. 

Effective Dates for ASU 2016-01

ASU 2016-01 says the following concerning effective dates:

For public business entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years.

For all other entities including not-for-profit entities and employee benefit plans within the scope of Topics 960 through 965 on plan accounting, the amendments in this Update are effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. All entities that are not public business entities may adopt the amendments in this Update earlier as of the fiscal years beginning after December 15, 2017, including interim periods within those fiscal years.

Also, the provision exempting nonpublic entities from the requirement to disclose fair values of financial instruments can be early adopted.

Initial Accounting for ASU 2016-01

An entity should apply the ASU 2016-01 amendments by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption.

The amendments related to equity securities without readily determinable fair values (including disclosure requirements) should be applied prospectively to equity investments that exist as of the date of adoption of ASU 2016-01.