Understanding Tests Of Controls And Substantive Tests Of Transactions In Auditing

Identifying and distinguishing between tests of controls, substantive tests of transactions, and substantive tests of balances

Auditing is considered as the process to examine and inspect the financial statements of the companies with the aim to find out any kind of material misstatements in them due to financial fraud or errors. In the process of auditing, the auditors have the responsibility to develop a detailed audit plan after taking into consideration all the required aspects (Louwers et al. 2015). First, they need to gain understanding about the nature of the entity along with industry of the entity so that they can identify the areas of material misstatements in the financial statements. In this process, the auditors are needed to apply the Audit Risk Model so that they can apply the appropriate risk rating like low, medium or high. Apart from these, it is also needed for the auditors to take into consideration the identification of the material account balances along with the related audit assertions with the aim to suggest the appropriate audit procedures with the aim to obtain the required audit evidences (Knechel and Salterio 2016). The main aim of this report is to take into account the various dimensions of risk-based audit plan for one of the Australian Securities Exchange (ASX) listed companies; and Admedus Ltd is taken into consideration for the report as the company is enlisted in ASX. Different parts of the report analyse the aspects like risk-based audit, determination of materiality, analytical procedures, sampling procedures and others.

Admedus Ltd is an Australian healthcare company involves in the development, commercialization and distribution of next generation medical technologies and devices (admedus.com 2018). The aim of the management of Admedus Ltd is to make themselves as a unique healthcare company with assets in research and development, products in advanced clinical trials resay for commercialization along with a successful business for sales, marketing and distribution of medical devices (admedus.com 2018).

Admedus Ltd operates in the healthcare industry of Australia. The healthcare industry of Australia is a major industry contributing largely towards the economic growth of the country over the years. In recent years, this industry has become able in fetching a revenue of $137 billion along with an annual growth of 4.6 per cent from 2013 to 2018 (ibisworld.com.au 2018). This sector provides employment of more than 842,000 employees in Australia. The Australian healthcare industry is high regulated due to insurance mandates, tax legislation, consumer protection and others. At the same time, this industry is highly competitive in the presence of some major companies (ibisworld.com.au 2018).

Selecting the most efficient and effective combination of audit procedures

As per the annual report of Admedus Ltd, there are certain major business risks. Commercial risk is a key business risk for Admedus Ltd. As per this, there is always a risk for the company that not all customers will use their products and services. After that, Clinical trial risk is another major business risk for Admedus Ltd due to the fact that the development of innovative products in this healthcare industry always has a risk element in it. The presence of intense competition in this industry is another major business risk as there is always a risk that the competitors of the company can develop better products and services than them (cdn.admedus.com 2018).

It needs to be mentioned that the financial statements of Admedus Ltd have the probability for the presence of material misstatements in them as there can be accounting errors at the time to prepare and present the financial statements. In addition, the involvement of certain judgments and assumptions can be seen to prepare the financial statements that can lead to material misstatements in them (cdn.admedus.com 2018).   

It can be observed that Admedus Ltd operates in a highly technological industry that has high regulations; and it can lead to inherent risk. After that, inherent risk can be affected as there is always probability that the misstatements in previous years has a likelihood to occur again. It can be seen from the 2017 Auditor’s report that the company had a loss of $12,676,21 along with a net cash-outflow of $12,467,781 in 2017. These aspects question the going concern status of the company that can lead to increased inherent risks. In addition, the possibility of errors and fraud in the financial statements along with the complex financial transactions affect the inherent risk of auditing (Griffiths 2016).

It can be observed from the 2017 Annual Report of Admedus Ltd that the company does not have a formal internal audit function and this lack of internal control can affect the control risks factor of the company. In addition, Admedus Ltd operates in a complex business environment where they have to comply with many rules and regulations of the government. This aspect affects the control risk of the company (Goh, Krishnan and Li 2013). These are the factors that can affect both the inherent and control risks of the company.

The audit risk model is as follows:

AR = IR*CR*DR

Where, AR = Audit Risk, IR = Inherent Risk, CR = Control Risk and DR = Detection Risk (Botez 2015). It can be seen from the above discussion that there is presence of both the inherent risk and control risk. According to the above discussion, there is doubt about the going concern status of Admedus Ltd due to massive cash outflow and loss. In addition, other inherent risk factors are highly technological and regulated industry and others. Thus, inherent risk can be considered as high for the company. After that, the company does not have any internal control mechanism and this aspect affects the control risk factor of the company. It can lead to the material misstatements in the financial statements. For this reason, this risk can also be considered as high for Admedus Ltd.

Developing audit work steps for each material account balance

Thus, it can be seen that both the inherent and control risk is high for the company; and thus, the acceptable level of detection risk needs to be low for the reduction of audit risk to an acceptable level (Lobo and Zhao 2013). Hence, the Audit Risk Model can be applied in the following manner:

AR = 5%, IR = 100% and CR = 80%,

AR = (IR*CR) * DR

5% = (100%*80%) * DR

DR = 0.05/0.8 = 6%

Thus, the substantive assurance will be 100% – DR = 100% – 6% = 94%. It can be seen from the above discussion that the ascertainment of detection risk is largely dependent on the factors affecting the inherent risk and control risk (Contessotto and Moroney 2014). Hence, all these aspects need to be considered at the time of the ascertainment of audit risk of Admedus Ltd.

The application of analytical procedures is a crucial aspect in the process of auditing as it helps in the identification of the material accounts of the companies. The analysis of relevant ratios is taken into consideration for the audit planning of Admedus Ltd. The description of these ratios are discussed below.

Ratios	Description
Gross Profit Ratio	It is a profitability ratio assists in measuring the efficiency of the companies in using their materials and labours for producing sales and products (Delen, Kuzey and Uyar 2013).
Net Profit Ratio	It is another profitability ratio that helps in measuring what percentage of each dollar earned by a business ends up a profit at the year end.
Asset Turnover Ratio	This particular ratio helps in measuring the ability of a firm for generating sales from their assets by comparing net sales with the average total assets (Delen, Kuzey and Uyar 2013).
Current Ratio	This ratio helps the ability of the companies to pay off their current liabilities with their current assets.
Acid Test Ratio	This ratio helps the ability of the companies to pay off their current liabilities with their liquid assets that can quickly be converted in cash (Delen, Kuzey and Uyar 2013).
Debt to Equity Ratio	This ratio shows the percentage of debt financing in the capital structure of the companies.
Equity Ratio	This ratio helps in measuring the assets that are financed by owner’s investments (Ongore and Kusa 2013).
Inventory Turnover Ratio	This ratio shows the efficiency of the companies in managing their inventories by comparing cost of goods sold with average inventory.
Debtor’s Turnover Ratio	This ratio measures how many times a business can turn its accounts receivable into cash (Ongore and Kusa 2013).

Profitability Ratios

An increasing trend is there in the gross profit ratio of Admedus Ltd. However, the above table shows massive net loss, but the loss is decreasing. Improvement can be seen in the asset turnover ratio of Admedus Ltd from 2015 to 2017 (Grant 2016).

Liquidity Ratios

Admedus Ltd has very strong liquidity position in the presence of large current assets as compared to current liabilities. In both of the current and acid-test ratios, decrease can be seen in 2016 and 2017 registers increase in these ratios (Delen, Kuzey and Uyar 2013).

Activity Ratios

As per the above table, an increasing trend can be seen in both of the above ratios that is a positive aspect for Admedus Ltd.

Solvency Ratios

An increasing trend can be seen in the debt to equity ratio. In case of equity ratio, decrease in this ratio can be seen (Serrano-Cinca and GutiéRrez-Nieto 2013).

In Admedus Ltd, for the calculation of the overall materiality of the company, 1.5 percent of the total revenue of 2017. Revenue of Admedus Ltd for the year is $22, 324, 415. Thus, the materiality amount is ($22, 324, 415 * 1.5%) = $334, 866. The auditor will consider any amount more than $334,866 as material misstatements in the financial statements of Admedus Ltd (Christensen, Glover and Wood 2013).

Designing a sampling plan for each material account balance

According to the amount of materiality, there are certain accounts in the financial statements of Admedus Ltd that can be material. They are Loss before Income tax from continuing operations, Net Sales, Current Assets and Current Liabilities. The auditor is needed to consider these accounts at the time of audit planning (Vîls?noiu and Buzenche 2014).

Account Balance	Amount	Assertion(s)	Audit Procedures	Audit Evidence
Cash and Cash Equivalent	$11, 260, 657	Existence: It is needed to assess whether this asset has existence. Completeness: The value of this asset is correctly recognized and recorded in the appropriate financial statement (Bratten et al. 2013).	The auditor is needed to examine all the confirmations from the bank. In addition, it is required to inspect the bank reconciliation statements (Byrnes et al. 2018).	The evidences are Statement of Reconciliation from the bank, certificates related to the confirmation from the banks, all the notes related to bank reconciliation and others.
Inventories	$4, 453, 871	Valuation: The requirement is to assess whether the valuation of inventory has been done appropriately. Completeness: The values of the inventory has been recognized in the financial statements. Existence: Inventories have existence at the end of the year (Bratten et al. 2013).	The required audit procedures are to carefully observe the physical inventory count of Admedus Ltd, reconciliation of the inventory count to the general ledger, testing of the inventories in transit, test the item costs, reviewing freight cost and others (Byrnes et al. 2018).	The required audit evidences are the reconciliation statement of the inventory, all the vouchers related to the purchase of the inventory and others.
Property, Plant and Equipment (PPE)	$2, 355, 996	Existence: PPE has physical existence in the balance sheet. Completeness: It includes the costs of capitalization. Rights and Ownership: Admedus Ltd has legal and ownership rights to the PPEs. Valuation: Whether the company has stated PPE at cost consistent method have been adopted for the calculation of depreciation and impairment. Presentation and Disclosure: Whether the company has property classified them in the balance sheet along with adequate disclosure (Bratten et al. 2013).	The required audit procedures are reconciliation of the summary of PPE along with accumulated depreciation, physical inspection of PPE, investigation of vouch additions and disposals, examination of the evidence related to legal ownership of PPE, analysis of the repair and maintenance accounts, testing of adherence to required disclosure and others (Byrnes et al. 2018).	The required evidences are all the documents related to the purchase of the PPE, ownership documents, patent related documents and others.
Intangibles	$6, 220, 328	Existence: intangible assets have physical existence in the balance sheet Rights and Ownership: Admedus Ltd has legal and ownership rights to the Intangible assets. Presentation and Disclosure: Whether the company has property classified them in the balance sheet along with adequate disclosure (Johnstone, Gramling and Rittenberg 2013).	The procedures are to obtain the schedule of the intangible assets, examination of the amortization and retirement provision of these intangible assets, testing of the fact that whether the intangible assets have been acquired on self-generated manner, examination of required disclosure and others (Kuenkaikaew and Vasarhelyi 2013).	The required evidences are the documents and papers related to the acquisition of the intangible assets and others.
Trade and Other Receivable	$4, 286, 473	Valuation: The company has made the valuation in fair value basis. Completeness: They have been recognized in the financial statements. Existence: Trade and other receivable has existence in the period end (Johnstone, Gramling and Rittenberg 2013).	The required audit procedures are tracing the receivable report to the general ledger, calculation of the receivable report, investigation of the reconciliation items, matching of invoice with the shipping logs, reviewing the cash receipts, obtaining the confirmation about the accounts receivable and others (Kuenkaikaew and Vasarhelyi 2013)..	The required evidences are the sales invoices, all the documents related to the accounts receivable, cash receipts, the trade receivable repots and others.
Trade and Other Payable	$1, 962, 635	Existence: The balances of accounts payable exists at the year end. Completeness: The trade payables are correctly recognized in the financial statements. Cut off: They have been recognized in the correct accounting period (Johnstone, Gramling and Rittenberg 2013).	The required audit procedures are obtain or preparation of a trail balance of accounts payable as of the balance sheet date, inspection of the vouch balance payable by supporting documents and reconciliation of the liabilities with monthly statement from creditors (Kuenkaikaew and Vasarhelyi 2013)..	The required audit evidences are all the vouchers related to the credit purchase along with all the documents related to the transactions involving the trade payables.
Employee Benefit Provisions	$754, 315	Existence: The balances of this provision exists at the year end. Cut off: These provisions have been recognized in the correct accounting period. Completeness: The company has recognized them in the financial statements (Lennox, Schmidt and Thompson 2018).	The required audit procedures are inquiring about these employee benefits plans with the responsible personnel in the organization, inspect whether the investment assets are held by the outside custodians or not, inspection of all the related documents of this provision and others (Bishop, Hermanson, and Houston 2013).	The needed audit evidences are all the documents as well as papers related to this employee benefit provisions.
Lease Make Good Provisions	$472, 745	Existence: The balances of this provision exists at the year end. Cut off: These provisions have been recognized in the correct accounting period. Completeness: The company has recognized them in the financial statements (Lennox, Schmidt and Thompson 2018).	The needed audit procedures are inquiring about this lease provision with the responsible personnel in the organization, inspection about the lease assets and others (Bishop, Hermanson, and Houston 2013).	In this case, certain documents are needed as evidence such as all the papers related to the lease agreement and others.
Deferred Considerations	$1, 418, 380	Cut off: The transaction related to these has been recognized in the correct accounting period. Completeness: It has been recognized in the financial statements in the appropriate manner (Lennox, Schmidt and Thompson 2018).	For this, the needed audit procedures are to inspection for the undisclosed contingencies in the company, evaluation of the materiality of the company and others (Bishop, Hermanson, and Houston 2013).	The required audit evidences are all the documents as well as papers related to this deferred consideration.

It can be seen from the above discussion that there are many assets as well as liabilities in the financial statements of Admedus Ltd. After that, it is needed for the auditor to develop a sampling plan for the identified material accounts. According to the above table, the presence of both the assets and liabilities can be seen under the material accounts (Elder et al. 2013). For this reason, it is needed for the auditor to select the Systematic Sampling Process for the material accounts. Under this process, the auditor is responsible for selecting the samples from large population at fixed interval. This sampling process is considered as the most efficient sampling process for the sampling of large number of material accounts. In this context, it needs to be mentioned that the auditor of Admedus Ltd will test 50 items for each of the accounts on systematic basis (Elder et al. 2013).

Conclusion

The above discussion involves in the development of an audit plan for Admedus Ltd by taking into consideration all the relevant aspects. It can be seen from the above discussion that it is needed for the auditors to obtain understanding about the audit client’s business and industry with the aim to know about their business risks. In addition, they are also needed to consider the factors having impact on the inherent as well as control risks. This report also sheds light on the fact that the auditors are needed to apply the audit risk model with the aim to gain the percentage of detection risks. Thus, it can be said that the ascertainment of detection risks depends on the assessment of both inherent as well as control risks. At the same time, it can also be seen from the above discussion that he auditors are also needed to apply various analytical processes for the assessment of the performance of the audit clients. In case of Admedus Ltd, the application of analytical process that is ratio analysis helps the auditor in identifying the material accounts. In addition, the auditor is also needed to apply certain percentage on revenue for ascertaining the materiality value. According to the above discussion, it can be said that certain assets and liabilities of the company are at the risk of material misstatement and the auditor is needed to apply substantive audit procedures on them after considering the appropriate audit assertions.

Understanding inherent risk, control risk, and detection risk

References

Admedus. (2018). About – Admedus. [online] Available at: https://admedus.com/about/ [Accessed 26 Dec. 2018].

Bishop, C.C., Hermanson, D.R. and Houston, R.W., 2013. PCAOB inspections of international audit firms: Initial evidence. International Journal of Auditing, 17(1), pp.1-18.

BOTEZ, D., 2015. Study Regarding the Need to Develop an Audit Risk Model. Audit financiar, 13(125).

Bratten, B., Gaynor, L.M., McDaniel, L., Montague, N.R. and Sierra, G.E., 2013. The audit of fair values and other estimates: The effects of underlying environmental, task, and auditor-specific factors. Auditing: A Journal of Practice & Theory, 32(sp1), pp.7-44.

Byrnes, P.E., Al-Awadhi, A., Gullvist, B., Brown-Liburd, H., Teeter, R., Warren Jr, J.D. and Vasarhelyi, M., 2018. Evolution of Auditing: From the Traditional Approach to the Future Audit 1. In Continuous Auditing: Theory and Application (pp. 285-297). Emerald Publishing Limited.

Cdn.admedus.com. (2018). Annual Report 2016. [online] Available at: https://cdn.admedus.com/2018/08/10114918/2015-2016-Annual-Report.pdf [Accessed 26 Dec. 2018].

Cdn.admedus.com. (2018). Annual Report 2017. [online] Available at: https://cdn.admedus.com/2018/08/10114914/2016-2017-Annual-Report.pdf [Accessed 26 Dec. 2018].

Christensen, B.E., Glover, S.M. and Wood, D.A., 2013. Extreme estimation uncertainty and audit assurance. Current Issues in Auditing, 7(1), pp.P36-P42.

Contessotto, C. and Moroney, R., 2014. The association between audit committee effectiveness and audit risk. Accounting & Finance, 54(2), pp.393-418.

Delen, D., Kuzey, C. and Uyar, A., 2013. Measuring firm performance using financial ratios: A decision tree approach. Expert Systems with Applications, 40(10), pp.3970-3983.

Delen, D., Kuzey, C. and Uyar, A., 2013. Measuring firm performance using financial ratios: A decision tree approach. Expert Systems with Applications, 40(10), pp.3970-3983.

Elder, R.J., Akresh, A.D., Glover, S.M., Higgs, J.L. and Liljegren, J., 2013. Audit sampling research: A synthesis and implications for future research. Auditing: A Journal of Practice & Theory, 32(sp1), pp.99-129.

Goh, B.W., Krishnan, J. and Li, D., 2013. Auditor reporting under Section 404: The association between the internal control and going concern audit opinions. Contemporary Accounting Research, 30(3), pp.970-995.

Grant, R.M., 2016. Contemporary strategy analysis: Text and cases edition. John Wiley & Sons.

Griffiths, P., 2016. Risk-based auditing. Routledge.

Ibisworld.com.au. (2018). Health Services – Australia Industry Research Reports | IBISWorld . [online] Available at: https://www.ibisworld.com.au/industry-trends/market-research-reports/health-care-social-assistance/health-services.html [Accessed 26 Dec. 2018].

Johnstone, K., Gramling, A. and Rittenberg, L.E., 2013. Auditing: a risk-based approach to conducting a quality audit. Cengage learning.

Knechel, W.R. and Salterio, S.E., 2016. Auditing: Assurance and risk. Routledge.

Kuenkaikaew, S. and Vasarhelyi, M.A., 2013. The predictive audit framework.

Lennox, C.S., Schmidt, J.J. and Thompson, A., 2018. Is the expanded model of audit reporting informative to investors? Evidence from the UK.

Lobo, G.J. and Zhao, Y., 2013. Relation between audit effort and financial report misstatements: Evidence from quarterly and annual restatements. The Accounting Review, 88(4), pp.1385-1412.

Louwers, T.J., Ramsay, R.J., Sinason, D.H., Strawser, J.R. and Thibodeau, J.C., 2015. Auditing & assurance services. McGraw-Hill Education.

Ongore, V.O. and Kusa, G.B., 2013. Determinants of financial performance of commercial banks in Kenya. International Journal of Economics and Financial Issues, 3(1), pp.237-252.

Serrano-Cinca, C. and GutiéRrez-Nieto, B., 2013. Partial least square discriminant analysis for bankruptcy prediction. Decision Support Systems, 54(3), pp.1245-1255.

Vîls?noiu, D. and Buzenche, S., 2014. Determining Audit Materiality in the Banking Industry–A Knowledge Based Approach. Procedia Economics and Finance, 15, pp.935-942.