 And welcome to the session in which we would look at the five types of other tests to determine whether the financial statements are fairly stated. Look, at this point in your course, we have looked at the five types except today we're going to look at them from an overall perspective. So you should be familiar with test of control because we already covered this. You should be familiar with the test of details transaction. We should be familiar with the test of substantive test of transaction. You should be familiar with analytical procedures as well as the test of detailed balances. But in this session, we're going to look at the overall picture. We're going to look at a map showing all these steps or all these steps, test how do they fit together in an audit. Now, before we start, if you are a CPA candidate or an accounting students, I strongly suggest you take a look at my website, farhatlectures.com. Most likely, if you're a CPA candidate, you have a CPA course and that's great. Keep your CPA course. It's great. You need it. What I serve is a supplemental tool, a useful addition to that CPA review course. And by helping you understand the material differently, you can understand your CPA review course better. You can perform better on the CPA exam. I can help you add 10 to 15 points by explaining the material differently. Your risk to try me is one month of subscription. Your return is potentially passing the exam. Are you willing to take that risk? And if not for anything, take a look at my website to find out how well or not well your university doing on the CPA exam. If you haven't connected with me on LinkedIn, please do so. Like this recording, share it with others as well. Connect with me on Instagram, Facebook, Twitter, and please connect with me on Reddit. So as I mentioned earlier today, we're going to be looking at those five tests starting with the first one. So I'm going to kind of count them, name them. The first one is the risk assessment procedure. That's the first basically procedure, test procedure, whatever you want to call it. And we talked about this. We had like almost a whole chapter about the risk of assessment procedure. It's basically assessing the risk of the financial statements due to error or fraud. Now, how do we do so? This is an overall picture. Well, we obtain understanding of the company, its environment, and its internal control. And specifically, when it comes to internal control, we are interested in the design and implementation of the internal control. So the first thing we do is we look at the overall picture of the company, management, industry, the big picture. This is called risk assessment procedure. Then after the risk assessment procedure, assuming we're going to rely on the internal control, we're making an assumption here. Now we're going to test the internal control. And why do we test the internal control for one purpose? Listen to me carefully. It's to assess the internal control. We're going to look a little bit. We're going to have one slide about the internal control. But we had one whole chapter. I have like maybe 12 recordings about internal control. So this is step two. But this is just an overview to see how all fits together. After we test internal control, we come down to the substantive testing. Under the substantive testing, we have now some people might say, two, I'm going to say three. Then I'll explain. Under substantive testing, now you are actually doing the test. You have what's called substantive test of transactions. That's one. So this is three. You might have test of details of balances. That's four. Okay. And usually those are under substantive testing. And the third one under substantive testing, which is the fifth for us, the fifth type is analytical procedures. Now in some textbook, what they do, they would consider those two test of transaction and test of details separate from analytical procedures. That's fine. If you, if your textbook or if you're going to look at them that way, but I like to keep analytical procedure under substantive testing. So those are the five things we're going to look at. We already finished one. So we're going to be looking at test of control. Basically, this is an overview. I'm going to do an overview of all of these because substantive tests of details, it's covered heavily in every cycle. Test of details cover heavily in every cycle and analytical procedures cover heavily in every cycle. And you already, you should know what they are. Okay. At this point, but I'm going to cover them again in every single cycle. Let's start with the test of control. Okay. Why do we test control? Why do we do this control again is to assess. I know I'm repeating myself, but it's important to assess the risk, the control risk for each transaction related audit objective. Remember, you only test the control if you are going to rely on it. Okay. If you believe it's effective, effectively designed and implemented. Otherwise, you don't test the control and say, I'm not going to use it. If you don't think it's good, you don't test it. Okay. So you assess the internal control and you assess the control risk at a level that reflect the relative effectiveness of those control at a medium, high or low. And we already talked about this. Okay. Now, how to obtain evidence about the internal control. Again, this is should be a review for all of you. You can do inquiries, talk to personnel, management, examine, which is usually the word review is used of appropriate documentation, records and report. Observation. That's how you do internal control. Observe activities. Make sure they don't know you are observing. Repreform, redo client procedures. And obviously before you do that, you want to understand the internal control. How do you do so? You perform a system walkthrough. And we spoke about system walkthrough one whole lesson. For example, you take a sales trans, you take the sales transaction from the beginning till the end sales transaction and credit approval. Okay. You'll start with the sales initiation till it's approved. You just walk through, just walk through system. Or you might select 50 sales transaction from various time during the year and examine them for whatever, whatever we are looking at for certain approval for certain procedures. This is how you understand the internal control. So you understand, then you assess, you test it to assess the internal control. Okay. So that's the test of control. And for example, you select 50 sales transaction to determine whether credit was granted before the goods of shipment. You just want to see if it was the credit granted before the goods were shipped. The next thing we're going to look at is that big area substantive testing. What's substantive testing? It's procedure to design, procedure design to test the dollar amount. So test of control. You're looking for something like yes or no. Do they do this procedure? Yes. Or no, they don't. This is test of control. This is test of control. When it comes to substantive testing, remember, now you are looking at the dollar amount, monetary misstatement. Okay. Directly affect the financial statements. Are they correct? Are they correct or not? The financial statements number as well. Obviously the disclosure. Okay. So the auditor relies on three types of substantive testing. I said two or three because again, some of you might say, you know, analytical procedure, keep it separate. I don't care whether you keep it separate or you combine it with substantive test of transaction, test of details and analytical procedures. This is what we had on the prior slide. Now I'm going to go over each one of those briefly. Again, I say briefly because we're going to go each one of those for every specific cycle, sales, expenditure, purchase of property, plant and equipment, cash, investment, payroll, personnel, HR, so on and so forth, inventory. So we're going to go through all of those. But in other sessions, which I already have on YouTube anyway. So substantive test of transaction or ST of T, if you want it for short. They are used to determine whether the seven related seven transaction related audit objective has been satisfied for each class of transaction. Here you are looking at transaction itself like transaction debit and a credit. So you look at that transaction. Now you want to remember the seven type, the seven transaction related audit objective, the seven transaction related audit objective. This should be a review for you. The first one is occurrence that the transaction that actually occur or the disclosure that actually happened to completeness that we include. All the transaction that already happened completeness three accuracy. What's accuracy is the information accurate and related disclosure accurate for posting and summarization. Are we transferring the information from from the recorded transaction in the journal to the sub to the subsidiary record and the general ledger. Basically, are we posting to our general ledger, which will eventually make it to the financial statement or not posting in a summarization. Classification. Are we classifying the accounts in the appropriate account. So when we have a transaction, is it being recorded. For example, if we purchase supplies, is it being recorded into supplies, supplies as an asset or is it supplies as an expense or is it recorded as cost of goods sold and which account are we doing. So what what's the classification. Six timing are we recording the transaction on the proper date. So we're not moving revenues and expenses back and forth transaction are recorded on the wrong day. This is the timing and seven presentation presentation is the auditor counterpart to management presentation and assertions. Basically, when they present, we have to check this and those are the seven transaction related audit objective and you should be again familiar with them. This is only a review and overview. Okay, but this is what the substance substantive test of transaction does. It will look at these seven transaction related audit objective test of details. They look at those as well. Now here we're focusing on the ending a general ledger balances. We're not looking at the transaction. Remember the transaction. For example, we debit cash credit revenue. Okay, this is a transaction. Balances is we're looking at the revenue account and the revenue account totaled one million. Let's say rather than revenue use account receivable is a better example. Debit debit account receivable credit sales. So we made the sales on account. This is a transaction. Now what happened is for account receivable, we're going to have a general ledger. For example, our account receivable general ledger is a million and this is what we're testing here. We're testing the total the test of detailed balances. Now we can look for the ending balances for the balance sheet or the income statement. Usually accountant or auditors use the balance sheet because it's the end of the year. We use the income statement for something else. We also look at the test of balance detailed balances for related disclosure because the disclosure has to match the balance. If we said we have 1.2 million of property, plant and equipment and the notes of property, plant and equipment. We need to show 1.2 million. Okay, examples of test of details would include confirmation of balances of account receivable. So you have ending balances. You're confirming the ending balances sales cutoff test making sure it's in the in the right time. Basically, those are two related sales cutoff test physical examination of inventory because when we count the end. It's the end of the end of the period examination of vendor statement of accounts payable. Okay, so why this type of test is essential? Why the test of details is essential? It's because usually the evidence provided in this test is coming from an independent party. The source document is coming from a third party. And if we know anything about evidence from our evidence chapter, that type of evidence is highly reliable. That's why the test of detailed balances is good is good. Okay, and just like the the previous test, you must satisfy all balance sheet related audit objective. Okay, for each balance, just like with the substantive test of transaction, just like with the substantive test of transaction test of detailed balances, you have to meet those seven audit related objective. How much of this testing do we do? So how much test of details do we do? It depends on many factors. It depends on how good or not good their internal control is. Okay, if the internal control is really good, we might do less of details of test balances. If it's not, then we have to do more substantive test of transaction. How much substantive test of transaction we did? Is it a lot or not a lot? Okay, and the analytical procedure. How much are we using analytical procedures in our testing? I just want to make you aware that when you are doing test of control, it can be performed separately. You remember that step one or more efficiently what some auditors would do. They will do the test of control and the substantive test of transaction together. It's basically it's more efficient. For example, apply the test of control involving inspection and performance to the same transaction and test that transaction for monetary misstatement. So you do the TOC and you do the dollar amount at the same time. It's just simply put, it's more efficient. You're saving time, you're saving time. The third type, the third type of testing of the dollar amount is analytical procedures. And hopefully the third type of substantive testing. Hopefully you know what analytical procedures are. Basically you are comparing a number to some expectation developed by the auditor. Okay, that expectation could be the prior year, the prior quarter, something to do with the industry. Now, when you do analytical procedures, you could have financial numbers to financial numbers or financial numbers to non-financial numbers. For example, financial numbers to financial numbers. For example, you could look at interest expense on the income statement and compare that relative to the balance sheet account of debt. Well, if you have 1 million of debt and with, you know, your overall interest rate is 10%, we should see 100,000 interest expense. So this is basically, this is an expectation. If you have a million dollar of debt and we know that your average interest rate is 10%, your interest expense should be around 100,000. That's, well, if the interest expense is 150, we need to question that. And if the interest expense is 70, we need to question that. It's based on the analytical procedures because they make sense. Or some companies, they have a stable cost of goods sold to sales. For example, some companies, you can look at some companies yourself. For example, if they have $100,000 in sales, they will have usually, you know, on average $60,000 in cost of goods sold and the profit is 40%. So, if we compute the gross profit percentage, the gross profit percentage is 40,000 divided by 100,000. It's 40%. Or cost of sales is 60%. And guess what? For a lot of companies, not all companies, but a lot of companies in many industries, these ratios are pretty stable. Pretty stable. So, when they sell something, usually 60% of it is cost, 40% is gross profit. So, what you do is you would see the first thing you want to compute those percentages and find out if something is unusual. For example, the cost of goods sold suddenly is 62. Or the cost of goods sold is suddenly 58. You might be saying, but what is one or two percent? You know, what's the big deal about one and two percent? Well, that's a big deal. If you have sales in like billions, if you have five billions in sales, then one or two percent, it makes a huge difference, okay? So, that's why those small changes, for example, for retailers, if you're looking at a company like Amazon or even Wegmans, not Wegmans, Whole Foods, their profit margin ratio is very small. They make a little bit amount of money. So, if it makes one percent, it's a huge difference in their cost of goods sold. So, you can look at that relationship. You can look at industry data. For example, you can look at hotel occupancy rate and revenue. For example, you're auditing a hotel in, I don't know, in the Poconos. And you know, under Poconos, the hotel occupancy from the industry data is 80% on average. And the hotel has 100 rooms. You would say, okay, if 100 rooms, 80% should be filled. And 80 rooms and times on average, they charge $200 per room. On average, then you can develop an expectation of the revenue for that company, okay? So, it should be around $16,000, if my math is right. Okay, that's nothing basically, but let's assume per month. 80% occupancy, they have 200 rooms. They have 80 rooms on average and $200 per room. So, per month, they should be getting around $16,000. It doesn't mean they might be getting more. They could be more than the industry average or less. But you want to see what's going on. Another one of those comparisons is sales per square foot. And this is basically good for retailers. There's industry data about various retailers. What's the sales per square foot? And basically for retailers, this is becoming less. It's going down and down for most retailers, especially after COVID. But like a company like Apple, their square per foot is the highest. It's just FYI, just as an informational thing. So, you need to know about analytical procedures. So, analytical procedures, you need to know they are required during the planning stage and the completing the audit stage. So, at the beginning and at the end, you have to do analytical procedures at the beginning and the end. What about in between? Okay, now, they could be the same analytical procedures or different one at the beginning or the end. In between, not required. So, as a substantive testing, analytical procedure is not required. But analytical procedures is a good way to kind of eyeball the numbers, see what's going on. I did a lot of analytical procedures. When we did audits, we did a lot of analytical procedures at the beginning, we did throughout the audit and at the end, especially the partner, the manager, the person that's in charge of the audit. I was never a partner or a manager, but I got to a point where I can, you know, I started to learn how they could immediately know what's, if there's something wrong or something unusual, if you understand the business, analytical procedures can give you a lot of good information. The purpose of them is they're easy, easy to use, and they could easily tell you what are the red flags in the company, what's going on. This number does not make any sense. At the beginning, I was like, wow, I thought my manager and my partner, I thought they were geniuses. But after two years, working on the audit, yes, I remember when they taught me this, hey, this makes sense now, inventory should not be this high or there's something wrong with cost of goods sold. Maybe there's a transaction that has been misclassified because it's too big or too small. So you'll get from the analytical procedures it gives you a lot of information. It provides a form of substantive testing, and that's why I put it under substantive testing. Some of you might disagree. It's by itself, that's fine, it's okay, but it's substantive testing. So if analytical procedure is reliable and it should be reliable, test of detail balances, they could be eliminated or the sample reduced, it's gonna save you a lot of time if you trust the numbers and if you're doing the right analytical procedures. And basically, what's analytical procedures? Taking two numbers and dividing them by each other and comparing them to some expectation. So how good is analytical procedures? Well, it all depends on the expectation developed by the auditor. If your expectations are good and precise, then it's good. Now, the smaller, you know, the smaller the time period, the better off you are. So if you are comparing year to year and for a company, it's not really a good comparison. You wanna compare maybe quarter to quarter or even month to month to kind of make sense of the data. So if we go back to that hotel example, I told you in the Pocono, you know, the monthly should be 16,000, but in the summer, they could only have, the monthly could be 5,000. So you don't wanna look at the whole year and compare year to year. You wanna compare January to January, January of last year to January this year to find out if there's a huge difference in those figures. So the smaller, the more disaggregated, the better off you are in those analytical procedures. The predictability of the relationship. You guys remember we talked about the retail industry. The retail industry, those are very stable industries. When they sell, they make 45% net profit and their gross profit is around 30 to 35%. So the industry is very stable. For example, if you're dealing with a software company, well, it's not stable because each project will have a different gross profit. So depending on the industry, whether you are using income statement numbers versus balance sheet number, income statement numbers, believe it or not, they're better because the income statement number, they go for the whole year. So sometimes they're up, sometimes they're down, but they average up. The balance sheet are point in time. So at the end of the year, that number could be way higher or way lower. So it's not really good for analytical procedure, the income statement, but you can use both. Also accounts subject to discretion like that, that expense where the company decides how much is that number, they could change their opinion from year to year, depending on the economic situation, their collection practices, what's going on in the economy. So really analytical procedures may not be the best. Also the reliability of the numbers you are using. If those numbers are being generated that you are using from good internal control system, then yes, analytical procedures is more reliable. Also if they're coming from industry, remember I told you about that hotel in the Pocono? Well, there's industry data. The industry data is an outside data, it should be reliable. Then it's average, then it's better than the analytical procedures are good. If the information is audited, especially after you are done with the audit, you're looking at audited data. And also when you're looking at the prior year, the prior year is audited data. So the ratios that you use are covered in much, much more in details and other lessons. And for every cycle, I do cover the ratio. So if you look at my auditing course, in every cycle I have like 10 to 15 minutes about ratios about the cycle. And I do have lessons about all sorts of ratios as part of my audit course or as part of my CPA exam review course. So if you are looking to study for the CPA exam, I hope you have a CPA course because you need it. But all what I can be is a useful addition to your CPA review course. Don't risk failing the exam. Try me out. I could be a solution for your problem one month and I could save you. Study hard, good luck, and of course, stay safe.