Question

Explain the purpose and each of the key components or steps of Phase II, perform tests of controls and substantive tests of transactions. Use the subsequent material for each of these steps or components as well as any online sources that you find to help you explain the steps.

Answer 1

The main components of perform tests of controls are as follows:

1. The control environment

2. Risk Assessment

3. Control Activities

4. Information and Communication

5. Monitoring

1. The Control Environment

The control environment is concerned with the actions, policies and procedures that reflect the overall attitude of the client's top management, directors, and owners of an entity about internal control and its importance.

The main actions to be performed in this step are as follows:

a) Integrirty and ethical values- Management actions to remove incentives that prompt a person to behave improperly.

b) Commitment To Competence- Management's consideration of the competence levels for specific jobs and how those translate into requiste skills and knowledge.

c) Management's Philosphy and Operating Style- Management, through its activities, provides clear signals to employees about the importance of internal control.

d) Organisational structure- Understanding the client's organisational structure provides the auditor with an understanding of how the client's business functions and implements controls.

2. Risk Assesment

Client management's identification and analysis of risks relevant to the preparation of financial statements in accordance woth GAAP.

Main actions to be performed are as follows:

a) Client Management's Risk Assesment- Client management assess risk as part of designing and operating internal controls to minimize errors and fraud. there are three steps involve which are as follows:

i) Identify factors that may increase risk

ii) determine significance of risk and likelihood of occurrence.

iii) Develop specific actions to reduce risk to an acceptable level

b) Auditors Risk Assessment- Obtain knowledge about management's risk assessment process by:

i) Determining how management identifies risks relevant to financial reporting

ii) Evaluating their significance and likelihood of occurence

iii) Deciding the actions needed to address the risks.

3. Control Activities

Policies and procedures that client management has established to meet its objectives for financial reporting

main functions are as follows:

a) Adequate segregation of duties

b) Proper authorisation of transactions and activities

c) Adequate documents and records

d) Physical control over assets and records

e) Independant checks on performance

4. Information And Communication

Methods used to initiate, record, process and report an entity's transactions and to maintain accountability for related assets.

5. Monitoring

Client management's ongoing and periodic assessment of the quality of internal control performance to determine whether controls are operating as intended and modified when needed.

Substantive tests of transactions

These are those activities performed by auditor to detect material misstatement or fraud at the assertion level.

Types of procedures

1. Analytical procedures

2. tests of detail

1. Analytical Procedures- This is one of the many financial audit processes which help an auditor understand the client's business and changes in the business and to identify potential risk areas to plan other audit procedures.

2. Tests of Detail- Obtains direct evidence for a sample.

Time consuming

Identify specific errors or misstement

EXAMPLE

Entity A has rent expense of 12,500 in it’s income statement. There are two ways the auditor can get comfort over this account.

1. First, the auditor could test using a test of detail and inspect every single rent invoice for every month. This is a long and ineffective process.
2. The second option is for the auditor to perform a substantive analytical procedure whereby a reasonableness test is performed. That is, a prediction of what the amount should be and a comparison against the actual with subsequent follow up for major fluctuations. This is likely to be much more efficient than a test of detail.

Analytical procedures generally provides less reliable evidence than the tests of detail. analytical procedures are applied in several different audit stages, whereas tests of detail are only apllied in the substansive test stage.