 Hello and welcome to the session in which we would look at which type of test auditing procedures to perform when we are conducting an audit. Now in the prior session we looked at the five type of test or audit procedures which are this should be a review, this slide should be a review, one is risk assessment procedures, two test of control, then we have the substantive testing under substantive testing, we have substantive testing of transaction, test of detail balance and analytical procedures. So we did learn about those concepts in the prior session. So in this session we're going to see when do we use the different tests, under what circumstances, what factors affect this and how these tests also interrelate with each other, when do we use analytical procedures, when do we use tests of details, when do we reduce our test of details, when do we increase our substantive testing so on and so forth. So basically how do they all fit together in an audit, in an audit. So make sure you view the prior recording just for an overview about these concepts. Now this topic is extremely important on the CPA exam as well as in your auditing course because if you walk into the exam without being comfortable with the type of test to perform, which type to select for the appropriate scenario, they can easily trip you because those are scenario based. So you cannot memorize it, you really have to understand it because it's scenario based. How can I help you? Forhatlectures.com does not replace your CPA review course. If you're studying for your CPA, that's great. Keep it whatever course you have, that's great. They're all good. The most, I can be the most useful addition to your CPA review course. I can explain the material differently. I can help you understand it so you can answer the scenarios. You can understand your review course better as a result. You can add 10 to 15 points to your CPA exam score. Your risk with me is one month of subscription. Your potential gain is passing the exam. Are you willing to take that risk? That's all what I'm asking you to do. And if not for anything, take a look at my website to find out how well or not well your university is doing on the CPA exam. I do have resources for other courses, CPA sections as well. If you haven't connected with me on LinkedIn, please do so. Like this recording, share it, connect with me on Instagram, Facebook, Twitter, and please read it. So this is the five type of tests. We already looked at it in the prior session to determine whether the financial statements are fairly presented. Now, which type of tests do we use? That's the question where there are several factors that affect our choice. So let's list some of the factors. One is the type of evidence that we have available, the availability of evidence. Well, what type of evidence do we have? We have eight types of evidence. And if you don't know what they are, go to my evidence chapter. And we're going to review them quickly here. But if you really want to know, you have to be comfortable with the type of evidence you have, because you have the test and you have to match the test with the evidence. And this is what we're going to be doing next. But it's very important that you know this. Also, the cost of each type of test. Well, certain tests cost more than others. When do we use one test over the other? The cost is important. And we're going to look at the cost. The effectiveness of the internal control. That's extremely important. And we talked about this when we talked about the internal control. If the internal control is effective, that's good. That's going to reduce our substantive testing and our test of details, which are costlier, which we'll see that in a moment. And the inherent risk of the account that we are dealing with, the situation. If there is more risk, well, we have to do more work. More work means it's cost us more. Less risk, less work to do. So those are the factors. And actually the three and four we looked at it in the internal control chapter. In this session, we're going to look at the eight type of evidence and the cost. We'll discuss those two. Okay, let's take a look at the eight type of evidence that I just mentioned. Physical examination one, confirmation two, inspection, observation, inquiries of the client, performance, analytical procedures and recalculation. You need to be familiar with those eight. There's one whole chapter about evidence and for the CPA exam, if you don't know your evidence, don't sit for the exam yet. Now for the audit procedures, we're going to look at test of control as an audit procedure, substantive test of transaction, substantive analytical procedure and test of detail balances. So those are the four types of test. Okay, now you might be saying, how about risk assessment procedure? This is when we understand the whole entity. It's not really an audit procedures by itself. So those are audit procedures and the risk of assessment, if you remember when we talked about those, determine, you know, the level of these four. Okay, but now we're going to match the audit procedure with the type of evidence. So this is extremely important when you are sitting for the exam, you want to be comfortable how these fits together because they can give you different scenarios and you have to be sharp in order to understand this. I'm going to start with the test of detailed balances and I'm going to tell you what goes with the test of detailed balances. The majority of them goes with the test of detailed balances. For the test of detailed balances, you could have physical examination. For example, you could examine inventory, you could have confirmation, like for a count receivable, you can do inspection. You can do inspection in any test. Okay, you can inquiries of the client. This test goes with everything. Inquiries of the client, you're going to see it's going to go with every test because just what is inquiries of the client? Talk to the client. You're always going to ask questions. You can do re-performance when you are doing test of detailed balances while you don't do analytical procedures number seven because that's specific to analytical procedures and you can do recalculations. So notice, test of detailed balances can be used that can use basically six of the type of evidence. That's the first thing I want you to see. Physical, notice that physical examination and inspection, those two are going to be specific to test of detailed balances. Okay, so just sorry, physical examination and confirmation, those two, one and two, they are specific to test of detailed balances. You want to know this as well. Now, when it comes to inquiries, as I told you, inquiries for everything, you can use inquiries for test of detailed balances. You can ask questions about test of detailed balances. If you have analytical procedure, you can ask especially about the analytical procedures. You want to use this to learn more about why the numbers are fluctuating or not fluctuating or whatever you want to know. Substantive test of transaction, you want to talk to them if there's anything that you want to know. Test of control, of course, this is one of the main things when you test of control. So it's for everything. Inspection also goes for everything except analytical procedures. So when it comes inspection, you're going to see that inspection basically goes for everything. You inspect things, you look at things. Repreformance also the same as inspection. So notice now, we're filling in inquiries of client, inspection, reproformance, the same thing. It goes for everything except analytical procedure because analytical procedures is taking two numbers and dividing them by each other. You don't need to reproform anything. Now, recalculation, mathematical accuracy, when you're computing mathematical accuracy, you do this when you are doing test of detailed balances and test of transactions. Now, you might be saying some people say mathematical accuracy should go with analytical procedures. No, analytical procedures is taken the number as given and or audited. They could be audited, but you're not looking for them for their mathematical accuracy because you assume they are good. That's why you are performing the analytical procedures. And remember that also observation goes with internal control. So those are the four for internal control and hopefully you know them. Inspection, observation, just inspection, inspection document, observing the employee what they're doing, inquiries of the client. That's a big one. And reproformance, going and running through the same transaction and again and again. Notice, reproformance also goes under substantive test of transaction. It could also go under test of details. So sometime when we are doing reproformance, we may do all three together or we might do reproformance for internal control and substantive test of transaction at the same time. So this is an important grid that you want to understand how the test of the test, the audit procedure fit the type of evidence. And if you really think about them, they should, some of them should make sense. Some of them you have to know, but you really have to understand. That's what I'm trying to say. Okay. So make sure you know this. Now, analytical procedures, obviously, analytical procedures is analytical procedures. And under analytical procedures, you ask questions and I'll tell you a story later on about analytical procedure actually soon. That's why when you ask questions about analytical procedures. So notice analytical procedures, only two things you can do with analytical procedures, the procedure itself and ask questions if something does not make any sense. You need to know internal control by heart. Test of details has the most and substantive testing basically know you can do inspection, inquiries, always, reproformance and re-computation. Okay. Now let's take a look at the cost of evidence. Now I'm going to show you the cost of evidence from the cheapest, from the cheapest cost of evidence to the highest. Now when we talk about cost of evidence, cost of evidence should not be the only consideration or the main consideration because I don't want you to think that auditors look and they will make a decision based on the cost because that's not good. It means if a procedure is costly, we will avoid it. Not at all. I don't want you to take that impression at all. Okay. I'm just showing you the cost of evidence for decision-making purposes, but not for to determine whether to undertake a decision or not. In a sense that you don't do something because it's cost effective or not cost effective. Okay. As an auditor. Okay. You do, you perform a procedure because it's the right procedures. But if you can't find a cost effective method to meet that procedure, that's fine. But the cost should not be the consideration for that. The cheapest one is analytical procedures. Basically running the numbers and most software nowadays, like you download the trial balance for the company and it will run all the analytical procedures for you, the one that you want to program it. Then comes risk assessment. Risk assessment is basically learning about the company and understanding their internal control. Then comes test of control. So notice assessing and testing are two different thing. When you assess, it's cheaper. All what you're doing is just like looking at it. Testing is doing steps. It costs more. This is when you do inquiries. This is when you do observation, inspection. So it's a little bit more. It's a little bit more involved. Okay. Then you have substantive test of details. And the most expensive is the test of detail balances. So it goes from the most, the most, from the least expensive, you know, to the most expensive test of detail balances. So the company, if they want to save money, in a sense, but, you know, performing the audit is try to minimize test of detail balances. And we're going to see how do they do, how do they do so? Let's talk first talk about substantive analytical procedure. As I said, it's the least costly. Why? Because it's easy to make computation in comparison. The computer will do that for you. How good is it? It's basically a red flag. The analytical procedures, remember, it's going to show you potential misstatement, not misstatement. It's going to tell you, look, you may want to look into this a little bit further. I'll give you an example. I'll give you an example, because now, because remember, you do the analytical procedures. And what else can you do with it is inquiries. I remember my first audit. Was it my first audit? I believe it was my first audit. I was auditing a building, basically a building that senior citizen live in, and they get subsidies from the government. So HUD, I'm not sure if HUD still exists, HUD, it's a government agency. They ask the owners to have an audit to make sure that you are following HUD rules and regulations for senior citizen. And one thing that I noticed on my first audit, it's basically, I noticed that their utility bill, specifically their water bill, okay, went up substantially, like went up like 30%. Okay. So I have data for the past four years. I don't remember the number. Let's make up the number. And the water bill for that building, let's assume it was just for the sake of illustration was 5,000. The year I was doing the audit, so year one, it was 5,000. Year two was 5,200. Year three, when I was doing the audit, the bill was 9,600. Just making this number up. I don't remember the number at all. This was a long time ago. But the point is, don't just comparing, comparing the numbers from year to year, what you do is you would tell the computer, the Excel sheet, compute the numbers and anything above a certain percentage, basically red flag, make it in red. And I find out that their utility bill was much higher. So, wow. Well, analytical procedure gave me this information. This is a red flag. All what I did is I asked them what happened. They had a breakage and they were wasting a lot of water. That makes sense. That's fine. Now they had a breakage. What does that mean? It means I want to look at the repair expense. If they have a breakage, I have to look at the repair expense. So you don't look at this. It's okay. I accept it. Well, the bill, obviously I would look at the bills and I'll say that they paid more. But to confirm this, I would take a look at the repair expense and the repair expense for that year was higher, like 40% higher because they had to hire someone to fix this water leakage. So everything makes sense. All what I had to do is look at the numbers, analytical procedure. So analytical procedures can tell you a lot about the company. Okay? If substantive analytical procedures are the primary evidence, okay? If you are using them as a primary evidence or you are using them to reduce tests of detailed balances, if that's what you're trying to do, like what I did here, basically, you know, I'm going to use analytical procedures for this account, then you have to have precise expectation. And my expectation was clear. As I told you, the utility bill should be around $5,000. Okay? Because the past two years was $5,000, unless in that town, which was Allentown, Pennsylvania, they increased the utility bill. And I was not aware of this. You know, that's another explanation. You know, the water bill doubled. And yes, then your water bill will double. But that's not what really happened. What happened is there was a reason and I had a good expectation and a precise expectation. I don't have to audit anymore because I'm comfortable with the numbers, okay? Which is easy and audit anyway. Just take out the bill for the 12-month and add them up. So it's not a big deal. But the point is the analytical procedure gave me that quick and dirty way to confirm. Okay? Now, you might involve some complex and advanced calculation for AP. So AP could be more and more advanced now with all the computerized system. But it's a good place to start. So that's the least costly. Risk assessment procedures and learning about the internal control, not as costly as other audits. It comes after a little bit costlier than analytical procedures. You're basically making inquiries and observation and performing some analytical procedures. This is what in the risk assessment, okay? Basically review and document, summarizing the client business operation, their management structure, and most of this information is publicly traded or the client gives it to you. So it's cheaper than any other relative to other tests. So this is the risk assessment. However, when you start to test the control, this is costlier than the assessment. So testing is costlier than the assessment, okay? Because you want to test the operating effectively, okay? Especially when these tests involve three performance. Three performance is going through the transaction again, that costs money. Now, if the system that they're using is computerized, okay, then you can test internal control more quickly. For example, if their sales on credit is compared to the account balance automatically, so you don't have to kind of check, you know, 50 samples, you could just let the computer test the computer, make sure that every time we have sales on credit, the computer checks the account balance for that customer before we grant them the sale. So it takes maybe five minutes just to double check, documented that yes, it's working, and if the system is working for one time, it should be always working, rather than pulling 50 sample documents and inspecting each one of them, okay? So this is the next one. The third one is substantive test of transactivity, that's the fourth one. Is it fourth or the third? I lost track of the numbers. So so we have, okay, this is one, two, test of control, three, yes, that's what I thought. Substantive test of transaction is four. This is the fourth, like in terms of cost, the fourth type, it costs more than the test of control, okay? Especially if you have re-performance, this should be not re-pronounced, re-performance cost, but if you're doing re-performance, it costs the same because it's going to require recalculation and tracing. This is re-performance, not re-pronounced, sorry, okay? Now in a big data environment, if the system is computerized and you have big data, you can perform substantive test of transaction fairly quickly, okay, for a large sample of transaction because the system can do it for you, okay? Otherwise, if it's not computerized, if it's not, if you don't have a lot of data, you might have to do it manually, which it takes more time. Test of detail balances is the most expensive cost the most, and you want to avoid this. Here you send confirmation, you might have to count inventory, and inventory is costly. You may think it's easy. Well, it depends on the type of the inventory. Are you counting gold? Now you might need a specialist, okay? I mean counting the gold and weighing the gold, it's easy. But how do you know that's the, that's the, you know, 24 carat or 18 carat or the type of carat or silver, or if you are dealing with computer chips, or you might be counting the jeans, pants, so that's easy. You can go in and count the pants, right? Also, the location of the inventory, is it nearby? Do you have to travel? How long do you have to travel? So on and so forth. Also, their internal control policies takes into account, you know, how easy or hard to count that inventory, okay? So auditor will need, we would want to minimize test of detail balances. Now we're going to see how this minimization happened when they all relate to each other. So now we understand that the cost, so this is the costlier. You want to avoid this at, you know, avoid test of detail balances, if you can find an acceptable alternative procedure. So let's start with the relationship between test of control and substantive testing. Substantive testing, remember, we're talking about the test of transactions and test of detailed balances. How did they relate? First you want to know the difference between test of control and substantive testing. What's the difference? Simple. When you find a deviation in the internal control, it only tells you that there's a likelihood, a possibility of a misstatement, okay? It doesn't tell you that there is a misstatement. You know, any deviation, if you tested the control and you find they are not following this procedure, well, that's fine. It doesn't mean there's a misstatement. That's a possibility. However, if you find an exception or an error in substantive test of transaction or in the test of details, then this is for sure a financial statement misstatement. So be careful. The reason I'm saying this is because just because you find an exception in the internal control, they're not following a procedure, it means the numbers are wrong. But when you find a number is wrong in substantive transaction that it's wrong. We have three level of control deficiencies, deficiencies, significant deficiencies and material weakness. When does it, when do we have to be very careful when we have two and three? When two and three exist, then there's, there could be material misstatement that exists in the financial statement. And again, possible. So you could have those two and not have any, but it's likely now that the internal control is not working and you might have material misstatement. So think about test of control basically also in a sense, they are red flag or early warning that what you're going to find in substantive testing, whether you are testing transaction or testing details, okay? So just an early warning, okay? So what you need to do once you have this early warning, you follow with test of transaction or test of details to confirm whether your fear is correct or not. So let's do the work in example. Let's assume we have an independent employee that's going to be verifying the quantity, price and extension of each sales order, then this employee would initial their name that they did it, okay? So what happened? The auditor is going to select some sample to verify whether this employee is doing their job. Well, if we find out that a significant number of invoices missing the initial teams, they're not doing their job, we have to determine the implication on the internal control over financial reporting. Like what's the issue here? Like how is that going to affect the internal control? How should we respond to this? Well, we can extend the test of duplicate sales invoices to verify extension and footing, which is this is the test of transaction or we can increase our sample size, we can increase N, which is part of the test of detailed balances. So if we see that there is a weakness, there's a lot of missing items, we don't make, you know, what we have to do is we have to do more work in test of transaction. Now again, be aware just because this individual MF lacks the initial, it doesn't mean that sales invoices are incorrect, think about it. If the transaction was initially entered correctly, the employee that originally entered the transaction did it correctly, then that initial of the independent employee is not relevant, okay? There's no issues in the sales invoices. So be aware of this, just because you have exceptions in the internal control, it means the numbers are mistated. But let's assume there's no document, there's no documents or only few were missing the initials. So now what we say, we say the control is effective. Let's assume there's no, no missing initials. Every sales invoice that we looked at the initials were there. How do we respond to this? Well, we can decrease. We may be able to decrease our substantive testing and test of details. This way we can save money on time, but we don't decrease, now be careful, we don't decrease to save money or time. We decrease as a response to effective internal control. And I just said, assuming that you've found the initials and every one of them, that they are doing their job, then you might be thinking about reducing and documenting why you reduced your test of detail balance and test of transaction, not because you save time, okay? You reduce them because the control are effective. As a result, you save time and money, okay? So it's the interest of the company to have good internal control because the auditor will build them less hours, okay? Auditor would still carry some performance and recalculation to provide assurance. You don't just say because they're all have the initial, I'm not going to do any work. You would still do so. Now, what some auditors do to be more efficient, what they do, they do this test as part of the original test of controls. When they're doing the control, they may also do the repreformance. Others may not do it, wait till the end to determine the sample size, okay? But notice if you have good internal control, if you have good internal control, you can reduce substantive testing, substantive testing. Why? Because you are relying on good numbers. Now, what's the relationship between and little procedure and substantive testing? Well, what's the relationship between them? Well, let's talk about little procedures first. Like test of control, it's only an indicator. It's a red flag. It doesn't tell you whether there is a misstatement or not. So unusual fluctuation is a red flag, not direct evidence. You have to perform, you have to perform substantive testing, you have to perform test of details. So when they told me that they had a breakage in the water system, well, I looked at the, I looked at, I inspected the bills. Yes, there was an increase for three months, the water bill was out of control. Then I looked at the repair expense, well, and the repair expense was high. So I did some substantive testing. If the analytical procedure does not raise a red flag, let's assume I saw it's like $5,000, $5,200, and $5,300 this year. That's fine. That's fine. I don't have to do anything with that utility expense account because it didn't raise any red flag. So a good substantive, so analytical procedure in the quote, a good substantive test for small balances, you know, supplies, prepaid, maybe certain expenses that don't change is not supposed to change a lot from year to year. Okay, that's analytical procedures will be a good substantive test. A good example, as I just told you, the water bill at that housing authority, a good example for you. That's a real good example. Now, what is the trade-off between test of control and substantive testing? Well, let's take a look at this graph. We have y-axis and the x-axis. On the x-axis, we're going to say this is the internal control effectiveness, the more to the right, the more effective it is. Okay, and on the y-axis, what we're going to have is audit assurance, and we want to reach, this is the acceptable audit assurance. So we want to reach an acceptable audit assurance. Now, what's going to happen is this. Obviously, the more effective the internal control is, okay, the more effective, the better off we are. But here's what's going to happen. The effective of internal control could be at point A, could be at point C, could be at point B. And here's what we're going to say. We're going to say that the maximum, when the internal control is effective, okay, this should be a straight line here. So it's going to go from here to here and go straight. Now, so this is the acceptable level of assurance. Let's look first at the, oops, let's look at the acceptable. So this red line here, I should have made that, let me make it in a different color because I have two reds. Now, this green line here. So you want to reach this level. And this is the line of acceptable assurance. I want to reach this line. Now, if my internal control is at point A, which is not as effective as point B, okay, now I have to perform this much of audit assurance from substantive testing. So I have to perform this much of audit assurance in form of what? In form of substantive testing because why my internal control is this point A, which is not effective. If my internal control is at point C, I might be able to complete this much. So let me highlight this area. So this area here is the maximum assurance in blue that my internal control can give me. So if my internal control effectiveness is at point C, then look, compare this line to this line, I have to do less substantive testing, ST substantive testing, okay. Now, if my level of assurance is way to the right at point B, notice I have to do even less than this one, less than this line. But notice, whether it's at point B, D, X, Y, Z, this is the maximum assurance. So simply put, I'm going to do this in a different color. This is the maximum assurance that I can get from the internal control this much, okay. So it helps. So the better internal control, the less substantive testing I have to do. But at some point it plateaus and I have to do substantive testing. Now, once I'm here, I may end up here, I may end up here, it depends on what I end up. But the point is, if you have really good control, even the maximum internal control, you can save a little bit in substantive testing, not that much. I hope this is a good picture. This is a good picture. Once again, at the end of this recording, I cannot emphasize this enough. This is an important topic for the CPA exam, as well as for accounting students. And by the way, some of you who are watching this, I know you've been emailing me and asking me to get this lesson done. So finally, I have it done for you. Check out my website, farhatlectures.com, invest in your career, invest in your career, invest in yourself. You have to pass the CPA exam once. So don't shortchange yourself. Good luck, study hard, and most importantly, stay safe.