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Audit Approaches

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 Audit Approaches

Essentially there are four different audit

approaches:
 The substantive procedures approach
 The balance sheet approach
 The systems-based approach
 The risk-based approach
  The substantive procedures approach
 This is also referred to as the vouching approach or
the direct verification approach.
 In this approach, audit resources are targeted on
testing large volumes of transactions and account
balances without any particular focus on specified
areas of the financial statements.
  The balance sheet approach
 In this approach, substantive procedures are focused on
balance sheet (statement of financial position) accounts,
with only very limited procedures being carried out on
income statement/profit and loss account items.
 The justification for this approach is the notion that if the
relevant management assertions for all balance sheet
(statement of financial position) accounts are tested and
verified, then the profit/loss figure reported for the
accounting period will not be materially misstated.
  The systems-based approach
 The approach whereby the auditor relies upon the entity’s
system of internal control
 This approach requires auditors to assess the
effectiveness of the internal controls of an entity, and
then to direct substantive procedures primarily to those
areas where it is considered that systems objectives will
not be met.
 Reduced testing is carried out in those areas where it is
considered systems objectives will be met.
  The risk-based approach
 In this approach, audit resources are directed
towards those areas of the financial statements that
may contain misstatements (either by error or
omission) as a consequence of the risks faced by the
business.
 ERCA is emphasizing the risk based approach.
 Risk based Audit tests

 Set audit objectives

- transaction related
- balance related
 Asses and evaluate internal controls
 Design and perform audit tests
 Analytical Procedures
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Why
Whatuse
areanalytical
analyticalprocedures?
procedures?
 Typically, Analysis
Variation analytical procedures are a quick way to point out
 unusual trends or activity in account balances
Ratio Analysis
 Trend Analysis

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 Performing analytical procedures may be
thought of as a four-phase process:

 Phase One – formulate expectations

(expectations),
 Phase Two –compare the expected value to the
recorded amount (identification),
 Phase Three – investigate possible explanations
for a difference between expected and recorded
values (investigation),
 Phase Four – evaluate the impact of the
differences between expectation and recorded
amounts on the audit and the financial
statements (evaluation).
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the auditor develops expectations of what amounts

should appear in financial statement account balances
based on prior year financial statements, budgets,
industry information and non-financial information.
Expectations are the auditor's estimations of recorded
accounts or ratios.
The auditor develops his expectation in such a way
that a significant difference between it and the
recorded amount will indicate a misstatement.

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 when the auditor compares his expected value with the recorded
amount.
 He knows that there is a point at which the difference between
expected value and recorded amount is material (for example, if
the difference is 20%) which could be called a materiality
threshold.
 In substantive testing, an auditor testing for the possible
misstatement of the book value of an account determines whether
the audit difference was less than the auditor's materiality
threshold.
 If the difference is less than the acceptable threshold, the auditor
accepts the book value without further investigation. If the
difference is greater, the next step is to investigate the difference.

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 the auditor undertakes an investigation of possible explanations

for the expected / recorded amount difference.
 The difference between an auditor's expectation and the
recorded book value of an account not subject to auditing
procedures can be due to misstatements, inherent factors that
affect the account being audited, and factors related to the
reliability of data used to develop the expectation.
 The greater the precision of the expectation, the more likely the
difference between the auditor’s expectation and the recorded
value will be due to misstatements.
 Conversely, the less precise the expectation, the more likely the
difference is due to factors related to inherent factors, and the
reliability of data used to develop the expectation.

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Evaluate the impact of the differences between expectation and

recorded amounts on the audit and the financial statements
(evaluation).
 The final phase (phase four) of the analytical procedure process
involves evaluating the impact on the financial statements of the
difference between the auditor's expected value and the recorded
amount.
 It is usually not practical to identify factors that explain the exact
amount of a difference investigated.
 The auditor attempts to quantify that portion of the difference for
which plausible explanations can be obtained and, where
appropriate, corroborated.
 If the amount that cannot be explained is sufficiently small, the
auditor may conclude there is no material misstatement.
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 Analytical Procedures (cont)
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What
 typesAnalysis
Variation of accounts are related?

 Sales and
Used to A/R,
note COGS variations
unusual and Inventory, PP&E
between and Depreciation,
certain related accounts or
Gaming Revenuesbetween
to note variations and Promotional
different Allowances,
time periodsetc.
for one account
 Also used to note variances between budgeted and actual amounts
 Why are the relationships important?

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 Analytical Procedures (cont)
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 Income
Time Statement
Periods accounts are typically reviewed using the
to Review
same month or period of time from one year to the next,
 Balance Sheet accounts are typically reviewed month to month
especially in the hospitality industry. WHY?
 or the accounts
These most current month
are also to the previous
compared audited period,
against budgeted amounts.
which is typically year end.

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 Analytical Procedures (cont)
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 Gaming
Ratio Specific Ratios
Analysis

 Hold
Use %
of ratios to analyze
 RevPAR
 Types of ratios?
 Average Daily Rate
 Current Ratio
 Occupancy %
 Debt to Equity
 Metrics against birr values (i.e. number of markers, fills per
 Inventory Turnover
ETB1,000 in drop)

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 Analytical Procedures (cont)
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Why
Trendwould
Analysis
this happen?
 Earnings
Review ofManagement
trends in accounts. This is part of variation analysis.
 Account balances climbing or declining at certain times of the
Bonuses
 year.
Proper Accounting
 Other unusual items

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 Analytical Procedures for Income and
Expense Accounts

Analytical procedure Possible misstatement

Compare individual expenses Overstatement or
with previous years understatement of a
balance in an expense
account
Compare individual asset and Overstatement or
liability balances with previousunderstatement of a
years balance sheet account that
will also affect an income
statement account
 Analytical Procedures for Income and Expense Accounts

Analytical procedure Possible misstatement

Compare individual expenses Misstatement of expenses
with budgets and related balance
sheet accounts
Compare gross margin Misstatement of cost of
percentage with previous goods sold and inventory
years
Compare inventory turnover Misstatement of cost of
ratio with previous years goods sold and inventory
 Analytical Procedures for Income and Expense Accounts

Analytical procedure Possible misstatement

Compare prepaid insurance Misstatement of insurance
expense with previous years expense and prepaid
insurance
Compare commission expenseMisstatement of
divided by sales with commission expense and
previous years accrued commissions
Compare individual Misstatement of individual
manufacturing expenses manufacturing expenses
divided by total manufacturingand related balance
expenses with previous years sheet accounts
 Tests of Controls and Substantive
Test of Transactions

Both tests of controls and substantive

tests of transactions have the effect of
simultaneously verifying balance sheet
and income statement accounts.
 Assessing Control Risk for Business Processes
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If control risk is set at the maximum – the auditor does not rely on controls.
Instead extensive substantive procedures are used.

If a reliance strategy is followed – the auditor determines if controls may be

relied upon.

If controls are operating effectively – the auditor may reduce control risk below
the maximum.

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Tests of Details of Account Balances – Expense Analysis

Expense account analysis:

 Repairs and maintenance

 Rent and lease

 Legal expense
 Tests of Details of Account
Balances – Allocation

Several expense accounts result from the allocation

of accounting data rather than discrete transactions.

These include depreciation, depletion, and the

amortization of copyrights and catalog cost.

The allocation of manufacturing overhead between

inventory and cost of goods sold is an example of
a different type of allocation that affects expenses.
 Detail Audit Testing
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Typically audit testing is done using samples or

scopes.
You also have to determine which accounts to test
and which specific items in that accounts also.
The detail testing is done in conjunction with
analytical procedures, observations, inquiries and
risk analysis to address all areas of concern.

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Methodology for Designing Tests of Details of Balances

Identify client business

risks affecting Phase I
other accounts
Set tolerable misstatement
and assess inherent Phase I
risk for accounts

Assess control risk for

Phase I
accounts
Methodology for Designing Tests of Details of Balances

Design and perform

tests of controls and
substantive tests
Phase II
of transactions
for the acquisition
and payment cycle
Methodology for Designing Tests of Details of Balances

Design and perform

analytical procedures
Phase III
for the acquisition
and payment cycle
Design tests of details Audit procedures
of account balances Sample size
to satisfy Phase III
balance-related Items to select
audit objectives Timing