Question

Phil's Home Handyman Services (PHHS) is a small business providing home maintenance services in Christchurch and surrounding areas. Phil is interested in purchasing some new machinery for his business and has approached a bank for funding. In order to be given a loan the bank has requested an audited financial report. Phil has approached your firm for this service and you have been allocated the task of auditing PHHS’s financial statements. Your initial review of the business indicates that a substantive testing approach would be appropriate and you are now preparing audit programmes. In particular, you are working on the testing of the revenue cycle. The information you have obtained from your review is as follows:  Phil usually works 50 hours a week. Part of this time is spent travelling between clients and is not charged to the clients. The remaining time is charged at $40 per hour, regardless of the task undertaken.  Phil is usually paid in cash, except for a small number of regular small-business customers whom Phil allows to pay on account on a monthly basis by cheque.  In all cases Phil provides the customer with a written receipt. Receipts are prepared manually from a receipt book purchased at a bookstore. The book contains prenumbered blank receipts, which are completed in duplicate.

REQUIRED: (a) Define ‘tests of controls’ and ‘substantive testing’, and then compare and contrast these two forms of audit tests.

b) For each of the following financial statement assertion categories, identify two substantive audit procedures you could use to audit revenue: (i) Accuracy and Cut-off (ii) Completeness (iii) Occurrence

Answer 1

(a)

A test of controls is an audit procedure to test the effectiveness of a control used by a client entity to prevent or detect material misstatements. Depending on the results of this test, auditors may choose to rely upon a client's system of controls as part of their auditing activities. However, if the test reveals that controls are weak, the auditors will enhance their use of substantive testing, which usually increases the cost of an audit.

S.No.	Basis of Comparison	Test of Control	Substantive Control
1.	Component	Test of controls is the testing tool for assessing control risk.	Substantive test is the control mechanism of controlling detection risk.
2.	Step	It is the second step in audit testing.	It is the third step in audit testing.
3.	Types	Test of controls can be classified into two types: Concurrent test and planned tests of control.	Substantive test can be classified into three types.
4.	GAAS	It has no specific formulation of GAAS.	It is done in accordance with die GAAS.
5.	Determination	It determines effectiveness and efficiency of internal control.	It determines fairness of financial statements.
6.	Basis	Test of control is the police end procedures.	It is done on the basis of monetary error.
7.	Timing	Tests of control are done in interim date.	Substantive test is done on the balance sheet date.

(b)

Accuracy and Cut–off : – amounts and other data relating to recorded transactions and events have been recorded appropriately, and related disclosures have been appropriately measured and described. In Cut–off transactions and events have been recorded in the correct accounting period.

Completeness : – All transactions and events that should have been recorded have been recorded and all related disclosures that should have been included in the financial statements have been included. This means that transactions that should have been recorded and disclosed have not been omitted.

Occurrence : – The transactions and events that have been recorded or disclosed, have occurred, and such transactions and events pertain to the entity.

(i) Accuracy and Cut-off

this means that there have been no errors while preparing documents or in posting transactions to ledgers. The reference to disclosures being appropriately measured and described means that the figures and explanations are not misstated. Relevant test;; reperformance of calculations on invoices, payroll, etc, and the review of control account reconciliations are designed to provide assurance about accuracy. Cut–off are that transactions are recorded in the correct accounting period. Relevant test; recording last goods received notes and dispatch notes at the inventory count and tracing to purchase and sales invoices to ensure that goods received before the year end are recorded in purchases at the year end and that goods dispatched are recorded in sales.

(ii) Completeness

This means that transactions that should have been recorded and disclosed have not been omitted. Relevant test;  select a sample of customer orders and check to dispatch notes and sales invoices and the posting to the sales account in the general ledger.

(iii) Occurrence

This means that the transactions recorded or disclosed actually happened and relate to the entity. For example that a recorded sale represents goods which were ordered by valid customers and were despatched and invoiced in the period. An alternative way of putting this is that sales are genuine and are not overstated. Relevant test; select a sample of entries from the sales account in the general ledger and trace to the appropriate sales invoice and supporting goods dispatched notes and customer orders.