Substantive Procedures for the Revenue and Collection Cycle [Video]

After the auditor has set the achieved level of control risk and determined the risk of material misstatement, the auditor can adjust detection risk.

The auditor can decrease detection risk by increasing the nature, timing, and extent of the substantive procedures to be performed. The purpose of the substantive procedures is to substantiate financial statement accounts and disclosures. The more substantive procedures an auditor performs, the better the auditor’s chances of detecting material misstatements.

There are two types of substantive procedures: analytical procedures and tests of details.

Analytical procedures substantiate accounts or disclosures by comparing recorded amounts (or ratios derived from recorded amounts) with the auditor’s independent estimates for those amounts. The auditor arrives at independent estimates by examining relationships between accounts (both financial and nonfinancial) to see if they are plausible. As part of this process, the auditor would:
• Compare financial information to information from comparable prior periods
• Compare financial information to budgeted information
• Examine relationships between related accounts during the period
• Compare financial information to the industry average
• Compare financial information with nonfinancial information

Analytical procedures are an important part of the audit because they are generally cheaper and less labor-intensive to perform than tests of details.

There are two types of tests of details: tests of transactions and tests of account balances.

Tests of transactions are designed to detect fraud or errors in individual transactions. An example would be vouching a sample of sales transactions back to the respective sales invoices, shipping documents, and customer orders to verify occurrence.

Tests of account balances, on the other hand, verify the ending balances of accounts. An example would be evaluating the adequacy of the allowance for doubtful accounts to determine whether the ending balance for accounts receivable is fairly stated.

Confirmation (a tests of account balances) is typically an important part of auditing the revenue and collection cycle. Confirmation refers to a process in which the auditor obtains evidence from direct communication with a third party about a management assertion.

With respect to receivables, confirmation involves the auditor asking customers about amounts they purportedly owe to the client. In short, the client is claiming that customers have promised to pay a certain amount of money, and the auditor is trying to ascertain whether this is true

There are two types of confirmation requests. A positive confirmation asks the customer to respond whether or not the balance is correct. A negative confirmation asks the customer to respond only if the balance is incorrect.

0:00 Introduction
0:30 Inverse relationship between RMM and detection risk
0:51 Types of substantive procedures
0:57 Analytical procedures
2:27 Tests of details
3:18 The confirmation process
3:45 Types of confirmations
4:44 Confirmation exceptions
5:08 Timing of confirmations
5:58 Alternative procedures
6:37 When not to confirm
7:48 Tolerable misstatement
8:10 Examining disclosures
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