CHAPTER 24

SUBSTANTIVE TESTS OF
TRANSACTIONS AND BALANCES

I. Review Questions

1. The cutoff bank statement is a bank statement sent by the bank directly to the
auditor, and it is usually for a fifteen or twenty day period following the
reconciliation date. The basic use of the statement by the auditor is to determine
whether outstanding checks were actually mailed before the reconciliation date.

2. All cash funds (and negotiable investment stock and bond certificates) should be
counted at the same time (simultaneously) so that money (or securities) cannot
be shifted from one location to another to conceal a shortage. If simultaneous
count cannot be made, as each fund (or each negotiable asset) is counted, it
should be locked and sealed until all are counted.

3. Kiting is the practice of recording a deposit of an interbank transfer in one

period, but delaying the recording of the disbursement until the next period –
thus double counting the amount of the transfer. It is used to cover up a cash
shortage. Auditors schedule all bank transfers around the year-end and examine
the dates deposited and disbursed per books and the dates deposited and
disbursed per bank. Thus, the auditors can determine if both sides of the
transfers are recorded in the same period and the proper period.

4. A “positive” confirmation is a request for a response from an independent party

who the auditor has reason to expect is able to reply. A “negative” confirmation
is a request for a response from the independent party only if the information is
disputed. Negative confirmations should also be sent only if the recipient can be
expected to detect error and reply accordingly.

5. Generally, vouching of documentation underlying receivables balances is

deferred until after confirmation. Then vouching is performed in regard to
accounts for which confirmations were mailed but no replies received.
Additionally, vouching may be used to gather evidence about account
discrepancies and disputes indicated on confirmation responses.

6. Sales cutoff is audited by selecting sales invoices, shipping documents, and

contracts created in the period (usually 10 days to two weeks) before and after
the fiscal year-end. The transactions are traced to the sales and receivables
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accounts to prove whether they were recorded in the proper period. Similarly,
recorded sales in this period may be vouched to underlying documents to
determine whether recording was in the proper period.

7. Refer to pages 458 to 460; 824 to 825; 827 to 828.

8. To prevent embezzlement through creation of fictitious credit memos, the

internal control system should provide that all credit memos be prenumbered,
controlled, and approved by a party independent of the preparer. Additionally,
credit memos should be approved only with proper supporting documentation,
e.g., a receiving report or correspondence.

9. Auditors get in the most trouble by missing overstated assets and understated
liabilities. Therefore, they need to audit for the existence of assets and the
completeness of liabilities.

10. Notes payable audit evidence obtained from a standard bank confirmation used
in the audit cash. Sales tax liability derived partially from the audit of sales
revenue (also commissions payable and excise taxes payable). Income tax
liability is derived from the net income number (audit of all revenue and
expense accounts).

11. The types of fraud and material misstatement with respect to cash disbursements
include:
1. The sending of checks to a fictitious person or company to accomplices
outside (coupled with internal record alterations).
2. The increasing (altering) of amounts payable to outside accomplices.
3. The intercepting of payments to a bank (coupled with internal record
alterations).
4. The drawing of checks payable to cash or bearer for one’s own use.

The procedures auditors use most frequently to detect cash disbursement

embezzlement schemes include:
1. A proof of cash – a recalculation – which reconciles cash receipts and
disbursements per the bank statement with receipts and disbursements
recorded in the accounts. The auditor will satisfy himself as to the propriety
of all checks payable to “cash” or bearer, NSF checks, and checks drawn to
officers and other employees.
2. The confirmation with all bank creditors of amounts owed, terms and
activity during the period.
3. The auditor’s test of purchase transactions – vouching, tracing and
recalculation in regard to purchase orders, supplier invoices, cash
disbursement journal and voucher register.
 Substantive Tests of Transactions and Balances 24-3
4. The auditor’s obtaining satisfaction of the proper separation of functions:
To establish that a proper separation exist, the auditor will not only examine
internal records purporting a proper separation, he will also examine
documents for compliance and observe personally the flow of operations
and activities.

12. The characteristics that the auditor is looking for in his review of the client’s
inventory-taking instructions include:
1. Names of client personnel responsible for the count.
2. Dates and times of inventory-taking.
3. Names of client personnel who will participate in the inventory-taking.
4. Detail instructions for recording accurate descriptions of inventory items,
for count and double-count, and for measuring or translating physical
quantities.
5. Detail instructions for making notes of obsolete or worn items.
6. Detail instructions for the use of tags, punched cards, count sheets, or other
media devices, and for their collection and control.
7. Plans for shutting down plant operations or for taking inventory after store
closing hours, and plans for having goods in proper places.
8. Plans for counting or controlling movement of goods in receiving and
shipping areas if those operations are not shut down during the count.
9. Detail instructions for compiling the count media (e.g., tags and punched
cards) into final inventory listings or summaries.
10. Detail instructions for pricing the inventory items.
11. Detail instructions for review and approval of the inventory count, notations
of obsolescence, or other matters by supervisory personnel.

13. As is true in other areas of a financial audit, verbal inquiry is a valuable tool for
obtaining preliminary evidence in the audit of inventory and cost of sales. For
example, the auditor can gain information such as the locations of inventory,
dates for the physical count, inventory held by consignees and public
warehouses, the cost-flow assumption used to price cost of goods sold and
inventories, and the pledging of inventory as collateral on loans.

In addition to providing preliminary evidence, verbal inquiry frequently

provides information about the status and value of slow-moving inventory,
apparently worn, damaged or obsolete inventory, and the existence of large
inventory stockpiles.

14. Cost of goods sold is generally audited through a combination of limited

vouching and extensive analytical procedures.

Inventory balances are generally audited through heavy reliance on observation,

vouching and recalculation, with much less emphasis on analytical procedures.
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15. The auditor can obtain preliminary evidence through physically observing plant
facilities and making verbal inquiries; for example, evidence can be obtained
regarding the quantity and size of assets, their location and apparent physical
condition, the activity surrounding them, and ownership of the facilities.

Further preliminary evidence of existence may be gained by a review of internal

management reports. Examples of such reports include capital expenditure
proposals, capital budgets, construction cost or acquisition cost postanalysis,
maintenance and repair reports, reports of sales or retirements, and insurance
and property tax analyses.

The preliminary evidence should be corroborated by auditor tracing to the

detailed records to ascertain that existing assets are recorded. Further, new asset
acquisitions should be traced to directors’ authorizations for expenditures and to
the capital budget.

16. To obtain relevant audit data about investment securities, auditors’ procedures
include:
1. Inspecting the securities in the presence of a responsible client officer.
2. Personally examining the securities while other negotiable fund sources are
sealed off or are being examined simultaneously.
3. Obtaining a written statement from the client’s representative that the
securities were returned intact.
4. Obtaining the information by confirmation from an independent party (e.g.,
trustee) who holds the securities.

17. Investment cost can be vouched to brokers’ advices, monthly statements and
canceled checks. The auditors can similarly vouch the price of securities sold
and investment income to this documentary evidence and then trace amounts to
income, gain and loss, and cash accounts.

18. If investments are sold at substantial losses early in the period following year-
end, there is evidence that the securities were overvalued at the balance sheet
date. Accordingly, the auditor will consider whether such securities should be
written down in the financial statements of the period under audit.

19. The long-term liabilities (and fixed assets and owners’ equity) are characterized
by a few large transactions, unlike the current assets and liabilities which have
numerous small transactions. Except for the initial year of an audit, the entire
balance is not verified each year. Only the changes in the account that occurred
in the current period need to be audited. The results of the audit of prior year’s
changes are recorded in “carry-forward” working papers for these accounts.

20. By vouching open purchase orders, inquiry of purchase personnel, and

confirmation with suppliers, the auditor is seeking to learn of commitments to
 Substantive Tests of Transactions and Balances 24-5
purchase inventories at fixed prices. If the client faces significant losses on
fixed-price purchase commitments, appropriate provision for the losses should
be made in the period’s financial statements.

21. “Off-balance sheet information” refers to information that relates to obligations

and commitments assumed by the clients that do not appear on the balance sheet
as current or long-term liabilities. Such information should be disclosed by the
client in the footnotes to the financial statements. Therefore, the auditors must
be alert to these items and gather evidence that will allow the auditors to
determine if the footnote disclosure is adequate. Such information includes:
leases, endorsements on discounted notes or others’ obligations, guarantees,
repurchase or remarketing agreements, commitments to purchase at fixed prices,
commitments to sell at fixed prices, legal judgment, litigation, pending
litigation.

22. The following matters are usually covered during the conference with the client
at audit completion:
a. Proposed audit adjustments;
b. Material internal financial control weaknesses;
c. Recommended footnote disclosures;
d. Type of audit report to be rendered.

II. Multiple Choice Questions

1. b 5. c 9. b 13. c 17. d
2. b 6. c 10. c&d 14. d 18. a
3. d 7. c 11. b 15. d 19. a
4. d 8. b 12. b 16. c 20. c

III. Comprehensive Cases

Case 1. a. The CPA’s test of the sales cutoff at June 30 should include the
following steps:
1. Determine what JETO’s cutoff policy is, review the policy for
reasonableness, and compare it to the prior year for consistency.
2. Select a sample of sales invoices (including the last serial invoice
number) from those recorded in the last few days of June and the first
few days of July.
3. Trace these sales invoices to shipping documents and determine that
sales have been recorded in the proper period in accordance with
company cutoff policy.
4. Determine that the cost of goods sold has been recorded in the period
of sale.
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5. Select a sample of shipping documents for the same period and trace
these to the sales invoice. Determine that the sale and the cost of goods
sold have been recorded in the proper period.
6. Review the cutoff for sales returns and allowances, determine that it
has been based upon a consistent policy and that there have not been
abnormal sales returns and allowances in July; this might indicate
either an overstatement of sales during the audit period or the need for a
valuation account at June 30 to provide for future returns and
allowances.

b. (1) The CPA will use the July 10 cutoff bank statement in his review of the
June 30 bank reconciliation to determine whether:
(a) The opening balance on the cutoff bank statement agrees with the
“balance per bank” on the June 30 reconciliation.
(b) The June 30 bank reconciliation includes those canceled checks
that were returned with the cutoff bank statement and are dated or
bear bank endorsements prior to July 1.
(c) Deposits in transit cleared within a reasonable time.
(d) Interbank transfers have been considered properly in determining
the June 30 adjusted bank balance.
(e) Other reconciling items which had not cleared the bank at June 30
(such as bank errors) clear during the cutoff period.

(2) The CPA may obtain other audit information by:

(a) Investigating unusual entries on the cutoff bank statement.
(b) Examining canceled checks, particularly noting unusual payees or
endorsements.
(c) Reviewing other documentation supporting the cutoff bank
statement.

Case 2. The procedure followed appears to be appropriate except that the

examination of detail transactions for three months might be considered to be
excessive in view of the exceptionally good internal control. A lighter test of
such transactions, designed to test the effectiveness of the control procedures,
might be devised.

The procedures followed should be supplemented by the following:

1. Review the company’s method of sales cutoff at year-end and test billings
and shipments (including returns) for an adequate period before and after
year-end to establish that cut-off procedures have been adhered to.
2. Examine collections in early part of subsequent period to determine if a
substantial portion of the receivables has been collected.
3. Examine agreements entered into with the distributors. If price protection
clauses are included, review the current price position and distributor
 Substantive Tests of Transactions and Balances 24-7
inventory positions to determine whether a reserve for such protection is
needed.
4. When a company deals with a limited number of customers, it is dependent
upon the continued solvency of all such customers.
5. Obtain a representation letter from appropriate company officials covering
the receivables.

Case 3. 1. a. Notes payable are authorized according to company policy (proper

authorization).
b. For each note outstanding or paid during the year, vouch to written
authorizing document.
c. Funds might be borrowed in the company’s name without the
knowledge of responsible officers.

2. a. Recorded notes payable are valid and documented (separation of

duties).
b. Observe the client personnel record-keeping duties.
c. Someone might intercept a check made out to a bank and convert
company funds to his or her own use. Notes payable records could be
falsified for a short time to hide the theft.

3. a. Valid liabilities are recorded and none omitted (sound error checking
practices).
b. Observe client personnel making comparisons. Review correcting
journal entries that result from the comparison.
c. Purchases or other liabilities may fail to be recorded and the error not
detected by any other means.

4. a. Recorded liabilities and cash disbursements valid and documented

(sound record keeping).
b. Inspect notes to see if they are marked “paid.”
c. Notes may get “paid” a second time if put back through the cash
disbursements system (intentionally or inadvertently).

Case 4. a. The fact that the client made a journal entry to record vendors’ invoices
which were received late should simplify the CPA’s audit for unrecorded
liabilities and reduce the possibility of a need for a further adjustment, but
the CPA’s audit is nevertheless required. If the client has not journalized
late invoices, the CPA is compelled in his testing to substantiate what will
ultimately be recorded as an adjusting entry. In this examination the CPA
should audit entries in the 2004 voucher register to ascertain that all items
which according to dates of receiving reports or vendors’ invoices were
applicable to 2004 have been included in the journal entry recorded by the
client.
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b. No. The CPA should obtain a letter in which responsible executives of the
client’s organization represent that to the best of their knowledge all
liabilities have been organized. However, this is done as a normal audit
procedure to afford additional assurance to the CPA and it does not relieve
him of the responsibility for doing his own audit work.

c. Whenever a CPA is justified in relying on work done by an internal auditor,

he should curtail (but not eliminate) his own audit work. In this case, the
CPA should have ascertained early in his examination that Ozone’s internal
auditor is qualified by being both technically competent and reasonably
independent. Once satisfied as to these points, the CPA should discuss the
nature and scope of the internal audit program with the internal auditor and
review his working papers in order that the CPA may properly coordinate
his own program with that of the internal auditor. If the Ozone internal
auditor is qualified and has made tests for unrecorded liabilities, the CPA
may limit his work in this audit area.

d. In addition to the 2005 voucher register, the CPA should consider the
following sources for possible unrecorded liabilities:
1. Unentered vendors’ invoice file.
2. Status of tax returns for prior years still open.
3. Discussions with employees.
4. Representations from management.
5. Comparison of account balances with preceding year.
6. Examination of individual accounts during the year.
7. Existing contracts and agreements.
8. Minutes.
9. Attorney’s bills and letter of representation.
10. Status of renegotiable business.
11. Correspondence with principal suppliers.
12. Audit testing of cutoff date for reciprocal accounts, e.g., inventory and
fixed assets.

Case 5. a. Lourdes should find in the audit working papers a planning memo
describing the client’s inventory-taking plan and notes about the auditor’s
first-hand observation of the instructions being given to counters, along
with a memo about the auditors’ observation of the counting. This memo
should tell about supervision of the audit staff, and the working papers (test
counts) should show the review signatures of the supervising auditors.

b. Working papers should document performance of these substantive

procedures for the existence and completeness assertions:
1. Conduct an observation of the company’s physical inventory count.
 Substantive Tests of Transactions and Balances 24-9
2. Scan the inventory compilation for items added from sources other than
the physical inventory count. . .
3. At year end, obtain the number of the last shipping and receiving
documents . . . Use these to scan the sales, inventory/cost of sales, and
accounts payable entries for proper cutoff.
4. Confirm or inspect inventories held in public warehouses.

Case 6. The three categories of major losses or manipulations in the area of

investments are: theft of diversion of funds, manipulation of accounting, and
business espionage. Business espionage is generally outside the sphere of
independent auditors’ interest.

Case 7. a. The objectives (specific assertions) for the audit of non-current

investment securities are to obtain evidence regarding the:
• Existence of the investment securities at the balance sheet date.
• Ownership of the investment securities.
• Cost and carrying value of the investment securities.
• Proper presentation and disclosure of the investment securities in
the financial statement.
• Proper recognition of interest income.
• Proper recognition of investment gains and losses.

b. The following audit procedures should be undertaken with respect to the

audit of Tess’ investment securities:
• Inspect and count securities in the company’s safe and safe deposit
box.
• Examine brokers’ statements to obtain assurance that all
transactions were recorded.
• Examine documents in support of purchases and sales of
investment securities.
• Inspect the minutes of the board of directors meetings.
• Review the audited financial statements of the (25 percent)
investee.
• Verify the equity method of accounting was used for carrying
value of the investment in Dee Industrial.
• Obtain a client representation letter that confirms the client’s
representations concerning the noncurrent investment securities.
• Verify the calculation of interest income.
• Review the propriety of the presentation and disclosure of the
securities in the financial statements.
• Make certain that the client representation letter includes the
proper assertions concerning accounts payable.
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• Investigate and resolve confirmation exceptions and other matters
requiring follow-up.
Case 8. a. The audit objectives in the examination of long-term debt are to
determine that:
1. All liabilities were properly recorded.
2. Items recorded as liabilities are bona fide obligations.
3. Interest expense and/or amortization was properly computed and
recorded.
4. The client is not in violation of restrictions or requirements imposed on
it by the terms of the loan agreement.
5. Satisfactory authority existed to enter into long-term obligation
agreements.
6. All long-term obligations are properly classified in the balance sheet.
7. Assets pledged as security are adequately disclosed.

b. The following procedures should be included in an audit program for the

examination of the long-term note between Odette and First National Bank:
1. Confirm the loan and terms of the agreement with the bank.
2. Review the agreement between Odette and the bank to determine that:
a. The debt is long-term (by reference to dates).
b. Provisions of the agreement have not been violated, e.g., that
Odette is complying with any restrictions on the payment of
dividends, on the amount of working capital to be maintained, or
on the uses to which the funds may be employed and is
maintaining the plant pledged as security for the loan.
c. The agreement was signed by person(s) having authority.
3. Trace the receipt of funds into the bank account and cash receipts book.
4. Check the computation of interest expense for the period May 1 to June
30, and trace the recording of the expense and the accrual on the books.
5. Determine that authority to borrow was granted and is recorded in the
board of directors’ minutes.