Question

Which of the following statements regarding directional testing is correct?

A.In order to test the existence assertion, an auditor may select a sample of items and trace to their corresponding source documentation.

B.In order to ensure that an asset has not been overstated, an auditor may want to vouch to source documentation.

C.In order to ensure that an expense has not been understated, an auditor may want to test the existence assertion.

D. In order to test the completeness assertion, an auditor may select a sample of items from the accounting records, and vouch to their corresponding source documentation.

Answer 1

Answer B In order to test the existence assertion , an auditor may select a sample of items and trace to their corresponding source documentation

Explanation is as follows

Directional testing could work the other way in that credits are tested for overstatement and debits for understatement. However, debits are tested for overstatement and credits tested for understatement (the „rule of thumb‟) because this direction addresses some of the more common issues that arise in the balance sheet (statement of financial position), such as:

 understatement of liabilities due to omission or oversight; and  overstatement of assets due to carrying values being higher than recoverable amount, or failure to recognise impairments.

For example, it is generally more difficult for income to be overstated due to error/irregularity. If you consider a company that has raised some fictitious sales invoices towards the end of the year to boost revenue, profits and net assets in order to avoid breaching loan covenants imposed by its bankers, then because revenue is overstated, this must mean a corresponding debit (i.e. trade receivables) are also overstated. By using the „debits tested for overstatement‟ rule, in this example the debits (trade receivables) will be tested directly for overstatement which will in turn detect the overstated revenues, if material.

Testing for overstatement (debits) Testing for overstatement starts with the amount recorded in the financial statements. The auditor will then work backwards to its source to confirm the occurrence and measurement of the recorded transactions and the existence, valuation and the entity‟s right to the assets.   

Testing for understatement (credits) Testing for understatement starts at the source (e.g. goods dispatched notes) and then works through the transactions to their ultimate destination in the financial statements. These tests ensure completeness of recorded transactions and balances. See how the financial statement assertions come into this methodology. In order to make this method of testing viable, the auditor must consider all the financial statement assertions (rights and obligations, valuation etc) as opposed to simply testing for completeness and existence of certain transactions and balances.