Substantive Testing Research Articles

Contract Analytics in Auditing

SYNOPSIS This paper proposes the Contract Analytics Framework (CAF), which provides guidance for incorporating textual analysis into audits of large numbers of contracts. Contracts are used extensively in auditing for risk assessment, analytical procedures, substantive testing, and audit review. While material contracts are carefully examined to assess financial implications, contracts perceived to be low risk are typically audited using standard sampling techniques. This proposed CAF facilitates effective and efficient audit analyses on full populations of contracts. We identify and describe six functional areas in the CAF: (1) Document Management, (2) Content Identification, (3) Cutoff Testing, (4) Record Confirmation, (5) Term Verification, and (6) Additional Audit Tasks. Based on auditing standards, we discuss the application of the CAF in the audit stages of risk assessment, substantive tests, and review. The framework is then implemented on a group of reinsurance contracts to demonstrate the feasibility of auditing full populations of contracts. JEL Classifications: M42; C88; O39.

Multidimensional Audit Data Selection (MADS): A Framework for Using Data Analytics in the Audit Data Selection Process

SYNOPSIS Advances in data analytics techniques allow auditors to process the entire population of transaction data to identify outliers (i.e., unusual/suspicious transactions) that are more likely to be subject to misstatement. However, these techniques often generate a large number of outliers, making it impractical for auditors to investigate them in their entirety when performing substantive tests. This study proposes a Multidimensional Audit Data Selection (MADS) framework that provides a systematic approach for auditors to use data analytics in the audit data selection process. The framework also addresses a common obstacle of applying data analytics to the entire population of data—dealing with a potentially large number of outliers. By identifying problematic items from the entire population using data analytics and then applying prioritization methodologies to the resulting items, this framework allows auditors to focus on items with a higher risk of material misstatement and ultimately enhance the effectiveness of the audit.

The Meaning of the Principal Purpose Test: One Ring to Bind Them All?

Due to the introduction of the Multilateral Convention (MLI), an ever-growing number of the world’s international tax treaties will contain a treaty-based anti-avoidance rule known as the principal purpose test (PPT). These PPT provisions will almost certainly play an extremely important role in preventing international tax avoidance. With the introduction of such broad and powerful anti-avoidance rules comes the risk of individual countries, through their revenue authorities and their courts, developing divergent and state-centric views as to the interpretation of the PPT. This risk is quite considerable, and there are many reasons why a harmonized basis of interpretation may not, in reality, emerge. If courts pursue an individual and diverse approach to the interpretation of the PPT, the same transaction will be viewed as being effective in one jurisdiction and ineffective in another. From a broader perspective, this is undesirable, and it should not occur for policy and interpretative reasons. Why is the case for interpreting the PPT consistently, with a common meaning, so compelling? There is one major reason, and it is an obvious one: the PPT can now be found in thousands of treaties, and it is exactly the same test in all of these. It is clear that an international autonomous meaning is intended to be introduced through the uniform adoption of the PPT. A universal interpretation may be possible if courts and revenue authorities apply a consistent approach to interpretation. The approach, detailed in this article, suggests that international tax treaties should be interpreted in accordance with (i) the ordinary meaning of the text of the PPT; (ii) due consideration of the context and the MLI’s object and purpose; and (iii) consideration of how the MLI, as a successive treaty, relates to the covered tax agreement (CTA) that it amends. This article analyses the PPT rule from a normative position and sets out an appropriate basis for the approach to interpreting the PPT. Using all available sources and reports, including examples of the application of the test, this article provides a comprehensive framework for interpreting the PPT and answers the following questions, amongst others: (i) How is the PPT designed to override other provisions in the CTA (including other general anti-avoidance rules)? (ii) Is the substantive test based on an objective assessment of the arrangement or transaction or on the subjective position/mind of the taxpayer? (iii) Does the proviso place an onus of proof upon the taxpayer?

The Effect of Fraud Risk Assessment Frequency and Fraud Inquiry Timing on Auditors' Skeptical Judgments and Actions

SYNOPSIS Identifying ways to improve and maintain professional skepticism, particularly for the purpose of reducing the risk of material misstatement due to fraud, continues to be a top priority for the auditing profession. This study examines two strategies for improving skeptical behavior in a fraud-related task: (1) practicing inward-directed skepticism through repeated risk assessments and (2) performing timely fraud inquiries of operational-level employees. Results indicate auditors made more skeptical judgments when revisiting and reassessing fraud risk assessments. Further, when auditors performed operational-level fraud inquiries prior to substantive testing, participants exhibited significantly greater increases in skeptical judgment than those who performed inquiries subsequently or not at all. We also observed a greater tendency toward skeptical action, but only on the part of participants who were highly skeptical by nature. These findings support the effectiveness of two strategies for improving skepticism throughout an audit engagement that can improve fraud detection.

FAKTOR-FAKTOR YANG MEMPENGARUHI PENGHENTIAN PREMATUR ATAS PROSEDUR AUDIT

The purpose of this study is: 1) knowing the sequence of audit procedure which most often signed off by auditor 2) testing effect of external and internal factors on premature signed off of audit procedure. The sample of this study are auditors of the Audit Board of the Republic of Indonesia (BPK RI) in the head office and the representative office. Sampling technique used is convenience sampling. Survey method for this study by distributing questionare. Data analysis uses Friedman test and regression logistic analysis with significance level (α) 5%.Friedman test result indicates that there are sequence of priority of audit procedure tend to be signed off. The most audit procedure which often to be signed off is internal auditor judgment and audit procedure which seldom to be signed off is substantive test. Logistic regression test shows that audit risk, materiality, professional commitment, and locus of control affect premature sign off of audit procedure, meanwhile time budget pressure, time deadline pressure, and role overload do not affect premature sign off of audit procedure.

Teaching Data Analytics Skills in Auditing Classes Using Tableau

ABSTRACTWe present a case for teaching data analytics skills in auditing classes using the data visualization software Tableau. We use the Tableau-embedded data file “US Superstore,” which we edited to include cash receipts and discounts to provide a complete order to cash cycle. Students learn how to create data visualizations and dashboards, and how to apply them to audit-planning considerations. Students then perform substantive testing of the revenue (order to cash) cycle and identify issues in the data that relate to revenue. We propose that this case material can be tailored by instructors to fit their particular needs and course curriculum. This case provides students with hands-on exposure to data analytic and visualization capabilities. Student feedback was very favorable and student comments indicated that the case was practical, realistic, and informative, and provided them a better understanding of data visualization.Data Availability: For data availability, please contact the corresponding author.

Putting Public Trust Doctrine to Work: A Study of Judicial Intervention in Environmental Justice

This article analyses the judicial intervention in enforcing the Public Trust Doctrine (‘PTD’) in Pakistan. According to the PTD, a government is responsible to protect certain natural resources like clean air, water, rivers, public parks, and forests. The government acts as a trustee to protect these unique natural resources. This article critically examines the application of the PTD by the superior judiciary in Pakistan. It does so by tracing out the theoretical framework, origin, and background of the PTD. The article analyses the development, application, and geological scope of this doctrine in Pakistan by critically examining the leading case law. It is argued that the superior judiciary in Pakistan has applied this doctrine in two ways — directly and impliedly. It has done so by relying on Indian and American case law and leading international environmental treaties. This article examines two widely applicable tests namely, the ‘Legislative Test Approach’ and the ‘Substantive Test Approach’ to assess the scope of the PTD. Finally, the article traces the limitations of the PTD. It concludes with the suggestion that policy makers should treat environmental rights as fundamental human rights by including it in Part II, Chapter I of the Constitution of Islamic Republic of Pakistan 1973.

Process-mining-enabled audit of information systems: Methodology and an application

Current methodologies for Information Systems (ISs) audits suffer from some limitations that could question the effectiveness of such procedures in detecting deviations, frauds, or abuses. Process Mining (PM), a set of business-process-related diagnostic and improvement techniques, can tackle these weaknesses, but literature lacks contributions that address this possibility concretely. Thus, by framing PM as an Expert System (ES) engine, this paper presents a five-step PM-based methodology for IS audits and validates it through a case in a freight export port process managed by a Port Community System (PCS), an open electronic platform enabling information exchange among port stakeholders.The validation pointed out some advantages (e.g. depth of analysis, easier automation, less invasiveness) of our PM-enabled methodology over extant ESs and tools for IS audit. The substantive test and the check on the PCS processing controls and output controls allowed to identify four major non-conformances likely implying both legal and operational risks, and two unforeseen process deviations that were not known by the port authority, but that could improve the flexibility of the process. These outcomes set the stage for an export process reengineering, and for revising the boundaries in the process flow of the PCS.

Using Visualization Software in the Audit of Revenue Transactions to Identify Anomalies

ABSTRACT Recent changes in the accounting profession require students to enter the workforce with technical and critical-thinking skills using large datasets. In an audit setting, an important skill is the ability to identify anomalies and risk factors in the client's data. This instructional case provides students with experience using visualization to identify anomalous transactions for further substantive testing based on relationships between financial data (revenues) and nonfinancial data (weather patterns). Students must also create a memo for the workpaper files that documents their findings, including recommendations for the audit team to select specific sales transactions for substantive testing. Aside from gaining experience with Tableau visualization software, this case will improve students' problem-solving and analytical skills by encouraging them to work independently and to break a complex problem into manageable pieces. This case is most applicable for implementation in undergraduate or graduate auditing or internal auditing courses.

Evidencing the Goals of Competition Law in the People’s Republic of China: Inside the Merger Laboratory

In the analysis of competition law the most fundamental question to be asked of any regime is that of what the goals of that regime are. The goals of competition law will determine the outcomes of cases, and transparency in goals will permit robust analysis of decisions against a clear benchmark, and facilitate firms’ analysis of transactional risk. Mergers which are notified to multiple authorities provide a distinctive opportunity to compare the operation of the different regimes in respect of, in essence, the same case at the same time. Where divergent outcomes are identified these may simply indicate that in the face of complex sets of facts different conclusions are drawn, or that competitive conditions vary across the relevant regimes. More importantly, divergence may suggest that different goals are being applied. This article focusses on the approaches taken in the People’s Republic of China (PRC), the United States and the European Union – the three ‘key’ merger regimes, from each of which a clearance is a ‘must have’ – in a defined set of merger cases in which at least two of these jurisdictions applied, covering the years 2013–2016. Recognizing the limitations pertaining to any such analysis, I compare the approaches taken across this set of merger cases seeking to explain and critique any divergence, focussing in particular on the more expansive approach to merger control demonstrated here to be applied in the PRC. The focus throughout is on the operation of the substantive test(s) of merger control, which provide a focal point for testing the goals of competition law and policy.

Earnings Autocorrelation, Earnings Volatility, and Audit Fees

SUMMARY This study proposes that earnings autocorrelation and earnings volatility are associated with audit fees. Autocorrelation and volatility are time-series of earnings characteristics that may affect an auditor's perception of inherent risk. In response to greater inherent risk, auditors should conduct more extensive substantive testing to reduce the overall risk associated with the audit. We find a negative (positive) association between earnings autocorrelation (volatility) and audit fees. The results indicate that a shift in the interquartile range in earnings autocorrelation and earnings volatility combined is associated with a 4.0 percent change in audit fees, which amounts to approximately $95,600 for the average firm-year observation in our primary sample. We also find that the relation between earnings autocorrelation and audit fees is attenuated for industry-specialist auditors, consistent with specialists responding to lower earnings autocorrelation more efficiently than non-specialists.

Proposals for a More Efficient European Merger Control

The reforms proposed in this paper pursue one common objective. Our aim is to reduce the burden of notifying and controlling unproblematic mergers, such that resources can be focused on the most complex cases. This would facilitate adequate assessment of complex transactions. These are more and more common in the new economy, where the variety of both potential harm and possible efficiencies has dramatically increased. Therefore, enforcement agencies now, more than ever, need to concentrate resources on complex cases and design procedures that allow for a thorough debate. This paper identifies three main avenues for the improvement of the ECMR. We first argue that the current time pressure during phase II mergers, and in particular after the SO has been sent, is counterproductive and against the interests of all parties. The tight time constraint does not allow for a serene and thorough debate that is needed. We propose to allow more time for the exchange of views in complex merger cases. In such cases, it is actually very challenging to have a debate through only one exchange of pleadings. This exposes the parties and the Commission to serious legal risks. While it is possible that just releasing time pressure will be sufficient to enable an adequate dialogue, it could be worthwhile to consider moving from one exchange of pleadings to two in merger control, just as it is done in Courts. Second, as turnover thresholds are not correlated with harm, they do not lead to a proper prioritization of cases in merger control in Europe. Thresholds could increase or decrease with no effect on the proportion of non-problematic mergers being notified. Regardless of the change in thresholds, this proportion would remain high, therefore wasting the scarce resources of all parties to the proceedings, including enforcement agencies. We show that no other threshold, or combination of thresholds, would perform better. Therefore, there is no room for further incremental improvements to the merger control system. We believe that only moving in the direction of a properly framed voluntary notification would significantly enhance the efficiency of merger control in Europe. This would be consistent with the 2003 reform in antitrust. However, the Commission should be able to intervene in due time against problematic mergers that are not notified. At the same time, the parties that decide not to notify need to know when it is safe to implement the merger. Therefore, we propose that parties planning to implement a merger of European interest should disclose their intentions to the Commission by submitting an electronic form containing readily available information about the merger. This would be similar to the HSR document used in the United States. We also propose that the parties make their intentions regarding the transaction public, or at least that they inform their largest customers and suppliers. The completion of these two steps would start the period when the Commission can receive complaints and use its market investigation tools. At the end of this period, the Commission could decide to take no action, clearing the way for the implementation of the merger, or to open proceedings. This would be more efficient for all parties than the simplified procedure or any reform of the notification thresholds. Here, the Commission would not be required to make a formal investigation and draft a clearance decision in all cases that are clearly not anticompetitive, as is currently the case. The parties would not be required to enter in formal contacts with the Commission in these cases. Last, we also propose to further the integration of the ECN, which, as the Commission mentions in its own documents, is not working perfectly yet. We first propose to increase the efficiency of one stop shopping by letting parties self-assess whether their operation affects trade between Member States. If they believe it does, they would then either voluntarily notify to the Commission, or simply disclose their intentions to merge by submitting the electronic form mentioned earlier. Member States would naturally be able to request a referral, but they would have the burden to prove that either trade is not affected or that they are better placed than the Commission to control the merger. Moreover, there has not been any systematic review of the effective application of the new substantive test by Member States. We would welcome such a review, followed by a public consultation on the ways to promote more convergence in the competitive assessments and rights of defence in the EEA.

The relationship between audit report delay and investment opportunities

Higher investment opportunities can increase audit risk. Therefore, external auditors need to extend the scope of their substantive tests and their audit work, and in turn, this leads to longer audit report delay. This study aims at investigating the relationship between audit report delay and the extent of investment opportunities among firms listed on Tehran stock exchange (TSE). We tested our hypotheses on a sample of 133 firms listed on TSE during the period 2006–2014, using multivariate regression analysis on panel data. Our results revealed that the audit report delay is longer for firms with higher investment opportunities. The research results also show that small companies, lost companies and companies that have major weakness in internal controls, are likely to have a longer delay in the audit report. The delay in the audit report of companies that had an independent auditor change is greater during the current period. The paper provides useful information for firms’ management and external auditors.

Use of High Quantification Evidence in Fair Value Audits: Do Auditors Stay in their Comfort Zone?

ABSTRACTResearch documents significant management bias and opportunism around the discretionary inputs of audited complex estimates, including fair value measurements (FVMs), which raises questions about auditors' ability to test these estimates. We examine how the degree of quantification in client evidence and client control environment risk influence auditors' planned substantive testing of management's discretionary inputs to FVMs. We find that auditors allocate a lower proportion of effort to testing the subjective inputs to the fair value estimate when the degree of quantification in the client evidence and level of client risk are both high. Further, this tendency persists even after auditors receive a regulatory practice alert reminding them to focus more audit effort on testing fair value (FV) inputs that are susceptible to management bias, and despite the auditors increasing their overall audit effort. Qualitative analyses of the procedures auditors selected indicate that inapt attention to the degree of quantification in evidence is a potential root cause of the difficulty auditors encounter when testing complex estimates. Our results imply that in situations where both quantified and non-quantified data are important to the audit, there is the potential for management to manipulate the evidence they provide to auditors to distract auditors from testing the discretionary inputs to complex estimates that are susceptible to management opportunism.Data Availability: Contact authors for data availability.

The importance of control environment in an organization for an independent auditor to determine nature,timing, and extent of substantive tests: An application in Turkey

This paper explains the effect of control environment as a one of the components of an internal control in performing substantive procedures by auditors. Control environment constitutes the tone of an organization and represents the understanding of control from the point of all of the employees in an organization. So to determine the nature, timing and extent of substantive test which the auditor will perform to detect material misstatements at the assertion level, auditors should examine the control environment and have a judgement on the structure of control environment. Because of the holistic effect of the control environment, it is one of the most effective determinants for auditors. Auditors are asked about some factors related with control environment in Turkey and the frequency of the data analyzed. As a result, the factors of control environment are examined and the importance of the control environment in auditors’ decisions is emphasized.

Comparative tests of the proper active grinding powers and maximum grinding temperatures, conducted on corrosion-resistant steel surfaces, using aluminium oxynitride and noble electrocorundum grinding wheels

This paper presents the results of comparative experimental tests of proper active powers and maximum temperatures, conducted on the circumference grinding of flat surfaces, made of grade 321 corrosion-resistant steel (1.4541), using modern aluminium oxynitride and noble electrocorundum vitrified-bonded grinding wheels. The tests were carried out in both up-cut and down-cut conditions. In both kinematic grinding aspects, the tested factors were determined by discrete increase of reductive grinding yield, applying increasing grinding-wheel in-feed to the workpiece and keeping the remaining grinding parameters at the constant level. The test results were later subjected to simplified statistical analysis, and an attempt was made at substantive test justification. It was demonstrated that, regardless of the assumed kinematic grinding aspects of steel grade 1.4541 (321), the values of all the comparatively tested values of aluminium oxynitride grinding wheels were, with increasing reductive grinding yield, lower than the corresponding values of the noble electrocorundum grinding wheels.

The Effects of Accruals Quality on Audit Hours and Audit Fees

We investigate whether auditors take into account accruals quality, a proxy for the cash flow risk associated with earnings, by adjusting audit hours and audit fees. Accruals quality tells investors about the mapping of accounting earnings into cash flows. Poor accruals quality weakens this mapping and thus increases this cash flow risk. We find a negative relationship between accruals quality and audit hours/fees, indicating that auditors increase their audit efforts by modifying audit procedures and substantive tests and charge higher fees for the increased cash flow risk. In addition, we find that both innate accruals quality and discretionary accruals quality are negatively related to audit hours and fees but that innate accruals quality is more likely to influence audit hours and fees than discretionary accruals quality. The results indicate that auditors incorporate the cash flow risk associated with accruals quality but that their response varies according to the source of accruals quality.

G & S Manufacturing: An Applied Auditing Case

This case provides students with the opportunity to gain hands on experience in the audit of cash disbursements, a voucher system and internal controls (or the lack there of) in the disbursement process. In particular, practical examples of concepts and procedures taught in an introductory auditing course, namely vouching, tracing, tests of controls and substantive testing are exemplified. The case includes sample invoices and a voucher register allowing the students to look at “actual” documents and ask good important questions. The case is broken down into three parts to allow students to receive feedback before continuing and the instructor plays the role of “consultant” providing an additional important learning opportunity. G & S Manufacturing is a small privately-held producer of steel products for the consumer market. As staff auditors performing part of the audit of G & S for the calendar year ended December 31, 2013 students will have to identify control deficiencies, substantive errors and other matters of concern in the audit of payables and cash disbursements. Students are provided with a copy of the voucher register for the month of December and all invoices relating to a selected sample of vouchers. The learning objectives of the case explicitly address the AICPA’s (American Institute of Certified Public Accountants) functional competencies of risk analysis, measurement and reporting; personal competencies of problem solving and decision making, and communication; and broad business competency of strategic/critical thinking.

Post Danmark II, or the Quest for Administrability and Coherence in Article 102 TFEU

The legal status of quantity rebates under Article 102 TFEU is unclear. In Post Danmark II, the ECJ has been asked to provide a substantive test to establish whether this practice amounts to an abuse of a dominant position. As the case law stands, two possible approaches can be followed. Quantity rebates can be assessed in accordance with the framework sketched by the Court in Michelin I, or they can be subject to the principles applying to other price-based strategies such as ‘margin squeeze’ abuses and selective price cuts. There are compelling reasons to follow the latter approach. The criteria set out in Michelin I were conceived for target rebates, which – unlike quantity-based schemes – are not presumptively legal under Article 102 TFEU. In addition, the said criteria are not administrable, in the sense that they do not make it possible to define in advance whether a given rebate scheme is lawful or unlawful. In practice, and in contradiction with the logic underlying Michelin I, it is sufficient for a competition authority or a claimant to identify some ‘loyalty-inducing’ features to establish an abuse. As such, they are not suitable for their application in disputes before national courts, or by national competition authorities.

EU merger review of the acquisition of non-controlling minority shareholdings: where to now?

Abstract On 9 July 2014, the European Commission (the Commission) published its White Paper “Towards more effective EU merger control”, which reviewed the operation of the EU Merger Regulation (EUMR) ten years after the introduction of the substantive test of “significant impediment to substantial competition” (SIEC) and proposed certain specific improvements, including the review of non-controlling minority interests under the EUMR. The 2014 White Paper followed approximately one year of consultation with Member States and interested parties, and was accompanied by a Staff Working Document, which analyses in more detail the considerations underlying the policy proposals in the 2014 White Paper, and an Impact Assessment, which analyses the potential benefits and costs of the various policy options considered. Less than six months after the consultation on the 2014 White Paper closed, Competition Commissioner Margrethe Vestager indicated that the Commission is reconsidering its proposals to allow it to review the acquisition of non-controlling minority shareholdings under the EUMR. This decision has been welcomed by many in the business and legal community as the “targeted transparency system” proposed by the Commission had raised a number of concerns regarding proportionality, legal certainty, cost and administrative burden. Whilst we await the Commission’s next move, this article considers whether non-controlling minority shareholdings should be subject to EU merger control and the extent to which the Commission’s originally envisaged system adequately dealt with the issues it sought to address. This article also proposes a number of principles that the authors suggest should be taken into account when designing a balanced system of merger review for acquisitions of non-controlling minority shareholdings in which the burden of the additional review is proportionate to the goals pursued.