How an Audit Works, Part 3: Testing Every Balance Sheet Account
Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
Parts one and two built the framework. This is where the auditor finally touches the accounts.
The temptation here is to memorize a list of procedures per account, which is how most people study fieldwork and why most people find it endless. There are dozens of procedures and they look unrelated. They are not. Nearly every one of them is a consequence of a single idea about which direction management is likely to lie, and once you have that idea, most of the list becomes predictable rather than memorized.
AUD 101: the complete audit process
- Client acceptance, engagement letter, documentation and planning
- Audit risk, materiality, assertions and types of procedures
- Substantive testing, sampling and the legal inquiry letter (you are here)
- Audit reports and opinions
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In this article
What is directional risk?
Companies overstate assets, overstate equity and understate liabilities, because that is the direction that makes the balance sheet look stronger. That one sentence determines which assertion matters most for every account you will test.
| Account | Incentive | Primary assertion | The auditor's question |
|---|---|---|---|
| Assets | Overstate | Existence | Is this real? |
| Revenue | Overstate | Occurrence | Did this happen? |
| Liabilities | Understate | Completeness | What is missing? |
| Expenses | Understate | Completeness | What was left out? |
| Equity | Overstate | Existence and accuracy | Is this calculated correctly? |
When a question asks which assertion a procedure addresses, ask whether the auditor is hunting for things that were invented or things that were omitted. Invented means existence and occurrence, so you are on the asset or revenue side. Omitted means completeness, so you are on the liability or expense side.
How do auditors test cash?
Cash carries high inherent risk for two separate reasons that pull in opposite directions. It can be stolen, which is misappropriation. And it can be overstated, which is fraudulent reporting. Different schemes, different procedures.
The two schemes to know
| Lapping | Kiting | |
|---|---|---|
| What it is | Misappropriation. An employee steals a customer payment, then applies the next customer's payment to the first account, and the next to the second, running laps to keep every account looking current. | Fraudulent reporting. A transfer between the company's own bank accounts is recorded as a receipt in the second account while the disbursement from the first is not recorded until after year-end, so the same money appears in both. |
| Who benefits | The employee | The company |
| How it is caught | Confirming receivables, comparing the detail of cash receipts to deposit slips, surprise cash counts | A bank transfer schedule listing every interbank transfer near year-end, showing the disbursement and receipt dates in both books and both banks |
The bank transfer schedule is the signature procedure for kiting, and it works because kiting requires the two dates to disagree. Line them up and the scheme is visible immediately.
The core procedures
| Bank confirmation | Sent to the bank, which replies directly to the auditor. Confirms deposit balances and also discloses direct borrowings. Tests existence. |
|---|---|
| Reperform the bank reconciliation | Verify that book balance ties to bank balance, that the opening figure agrees to the bank statement and the closing figure to the general ledger, and that outstanding checks and deposits in transit are legitimate. |
| Cutoff bank statement | A statement covering roughly the first ten days after year-end, sent by the bank directly to the auditor. It shows whether the outstanding checks and deposits in transit on the reconciliation actually cleared afterwards, which is how you catch fictitious reconciling items. |
| Bank transfer schedule | Detects kiting, as above. |
Why confirmations and cutoff statements go directly to the auditor. The client never handles the evidence. That is the entire source of their reliability, and it is why a confirmation the client offers to collect on your behalf is worth nothing.
How do auditors test receivables and revenue?
They are tested together because they share a journal entry: debit receivables, credit revenue. Evidence about one is evidence about the other.
Confirmations
Confirmation of accounts receivable is presumptively required when receivables are material. The auditor may overcome that presumption, but must document why, and the acceptable reasons are narrow: the balance is immaterial, confirmations would be ineffective, or the assessed risk is low and other substantive procedures address it.
| Positive confirmation | Negative confirmation | |
|---|---|---|
| Asks the customer to | Reply either way, agreeing or disputing | Reply only if they disagree |
| Evidence strength | Stronger, because silence is not treated as agreement | Weaker, because silence could mean agreement or that nobody read it |
| Use when | Default choice, and required where risk is higher | Only when risk of material misstatement is low, there are many small balances, few exceptions are expected, and recipients are unlikely to ignore the request |
All four of those negative confirmation conditions must hold together. A question that gives you three of them and quietly breaks the fourth is testing whether you know it is a conjunction.
The rest
| Subsequent collections | Where a confirmation is not returned, examine cash received after year-end. Payment after the date is strong evidence the balance was real at the date. This is the standard alternative procedure. |
|---|---|
| Scan the aging | Old balances may be uncollectible, so this tests valuation through the adequacy of the allowance rather than existence. |
| Cutoff testing | Examine shipping documents either side of year-end to confirm sales landed in the right period. |
Two procedures, two assertions. Confirmations test existence, meaning the customer really owes it. The aging tests valuation, meaning the amount will really be collected. A receivable can pass the first and fail the second, which is precisely what happens when a real customer becomes insolvent.
How do auditors test inventory?
Three risks: it may not exist, it may be counted wrong, and it may be obsolete and carried above what it will fetch.
Where inventory is material, attending the physical count is presumptively required. As part two's questions covered, alternative procedures can substitute when attendance is impracticable, but the starting position is attendance.
What the auditor actually does at the count
A common misconception is that the auditor merely watches. The auditor does two things.
The auditor observes the client's count procedures, judging whether the process is being run properly and whether the client's controls over the count are working. And the auditor performs test counts, personally counting selected items and comparing them to the client's records. Test counts are direct evidence, not observation, and they are the reason the auditor's presence produces evidence rather than merely reassurance.
Test counts run in both directions, and the direction determines the assertion:
| Direction | Procedure | Assertion |
|---|---|---|
| Floor to sheet | Select items physically present in the warehouse and trace them to the count sheets | Completeness |
| Sheet to floor | Select items on the count sheets and find them in the warehouse | Existence |
The auditor does not count all the inventory, and does not simply stand and watch either. The client counts everything; the auditor observes the process and independently test counts a sample. Both halves matter, and answer choices are built on candidates who only know one of them.
The other inventory issues
| Obsolescence | Look for dusty, damaged or slow-moving goods during the count. Feeds the valuation assertion and the lower of cost or net realizable value question. |
|---|---|
| Consignment | Goods held on consignment belong to someone else and must not sit on the balance sheet. This is rights and obligations. |
| Third-party locations | Where inventory is held in a public warehouse, confirm with the custodian, and where the amount is significant, do more than confirm. |
| Cutoff | Goods received or shipped around year-end need to fall in the right period, which usually means examining receiving and shipping documents either side of the date. |
How do auditors test investments?
Investments are securities the company holds in other entities. The dominant concern is valuation, since the amounts often rest on estimates rather than on a price anyone paid recently.
| Recalculate income | Independently compute what the investment should have produced and compare it to what was recorded. A $1,000 bond at 5% should produce $50 of interest income for the year. A holding of 1,000 shares paying a cash dividend of $0.40 per share should produce $400 of dividend income. |
|---|---|
| Confirm with the custodian | Where a third party holds the securities, confirm directly with that custodian. Tests existence and rights. |
| Inspect securities held internally | Where the company holds certificates itself, physically inspect them, ideally at the same time as the cash count so nothing can be moved between the two. |
| Test the valuation | Quoted prices for actively traded securities. For anything without an observable price, evaluate the model and its inputs, which is frequently where an auditor's specialist appears. |
A stock dividend is not income. Receiving additional shares gives you nothing new in economic terms, since the same claim is now divided into more pieces. There is no income to record; the existing basis simply spreads across the larger share count. Only a cash dividend produces dividend income, and the exam does use stock dividends to catch people who calculate a percentage without asking what actually arrived.
Segregation of duties for investments
| Function | Who |
|---|---|
| Authorization | The board or senior management approves purchases and sales |
| Record-keeping | Accounting staff make the entries |
| Custody | A third-party custodian holds the securities |
How do auditors test fixed assets?
Property, plant and equipment involves three separate events over an asset's life: acquisition, depreciation and disposal. The roll forward organizes all three.
A parallel roll forward runs on accumulated depreciation. Together they let the auditor tie the movement in the year to the general ledger rather than testing a balance in isolation.
| Additions | Vouch to invoices and approvals. Confirms existence and that the amount capitalized is right. |
|---|---|
| Capitalize or expense | Did routine repairs get capitalized to inflate assets and income? This is classification, and it is the most common fixed asset manipulation. |
| Depreciation | Recalculate using the method, useful life and salvage value the client claims to apply, and check those assumptions are reasonable. |
| Disposals | Recalculate the gain or loss as proceeds less net book value, and confirm the asset and its accumulated depreciation both came off the books. |
| Impairment | Consider whether carrying amounts are still recoverable, particularly for idle or underperforming assets. |
How do auditors test accounts payable?
Here the direction flips. Everything above hunted for things that were not real. From this point the auditor hunts for things that are missing, because understating liabilities is what improves the picture.
| Search for unrecorded liabilities | Examine cash disbursements after year-end above a threshold, and unmatched receiving reports and vendor invoices. For each, ask whether the obligation existed at year-end. If it did and no payable was recorded, liabilities are understated. This is the signature completeness procedure. |
|---|---|
| Reconcile vendor statements | Compare vendor statements to the recorded balance. A vendor claiming more than the client recorded is exactly the exception you are looking for. |
| Scan the aging | Old balances may no longer be valid obligations. |
| Cutoff testing | Receiving reports either side of year-end confirm purchases landed in the right period. |
Why payables are rarely confirmed the way receivables are. Confirming a recorded payable proves the recorded ones are right, which is the wrong question. The risk is the payable nobody wrote down, and a confirmation sent to a vendor you do not know you owe never gets sent. This is why the search procedure exists and why it starts from cash going out rather than from the ledger.
How do auditors test notes payable?
Debt runs on its own roll forward and touches both statements.
| Document | What it gives the auditor |
|---|---|
| Debt agreement | Principal, rate, term, repayment schedule, and any covenants or collateral |
| Amortization schedule | The split of each payment between principal and interest, used to recalculate both the roll forward and interest expense |
Three things to get right. Completeness, since the risk is unrecorded borrowing, which is why the bank confirmation asking about direct borrowings matters here as well as for cash. Classification, splitting the portion due within a year from the long-term balance. And covenants, because a breach can make long-term debt immediately callable, which reclassifies it as current and can raise going concern questions.
How do auditors test equity?
Equity accounts are typically few in number and large in size, so testing is close to complete rather than sampled.
| Board minutes | Read them for authorization of share issuances, buybacks and dividend declarations. Minutes are the authorization evidence for everything in equity. |
|---|---|
| Share transactions | Trace issuances and repurchases to the underlying documents and to cash. |
| Dividends | Recalculate declared amounts against shares outstanding at the record date. |
| Transfer agent | Where an independent registrar or transfer agent is used, confirm shares issued and outstanding directly. |
The full account map
| Account | Primary assertion | Key procedures |
|---|---|---|
| Assets, where the concern is overstatement | ||
| Cash | Existence | Bank confirmation, reperform reconciliation, cutoff bank statement, bank transfer schedule |
| Receivables | Existence and valuation | Confirmations, subsequent collections, scan the aging, cutoff testing |
| Inventory | Existence | Attend the count, observe procedures, test count both directions, obsolescence review |
| Investments | Valuation and existence | Recalculate income, confirm with custodian, inspect certificates, test valuation inputs |
| Fixed assets | Existence and classification | Roll forward, vouch additions, recalculate depreciation and disposals, capitalize or expense review |
| Liabilities, where the concern is understatement | ||
| Accounts payable | Completeness | Search for unrecorded liabilities, vendor statement reconciliation, cutoff testing |
| Notes payable | Completeness and classification | Debt roll forward, read the agreement, recalculate interest, test covenant compliance |
| Equity, where the concern is overstatement | ||
| Retained earnings | Accuracy | Recalculate the roll forward |
| Share capital | Existence and accuracy | Read board minutes, trace transactions, confirm with the transfer agent |
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How does audit sampling work?
No audit tests everything. The auditor tests a subset and reasons from it to the whole population, and sampling is the discipline that makes that reasoning defensible.
Two types, decided by what you are measuring
| Attribute sampling | Variable sampling | |
|---|---|---|
| Used for | Tests of controls | Substantive tests of details |
| Measures | A rate. How often is the control not followed? | A dollar amount. Is the balance materially misstated? |
| Answer looks like | A percentage | A misstatement in currency |
Probability-proportional-to-size sampling, also called monetary unit sampling, is the common substantive method. It gives larger items a proportionally greater chance of selection, which is efficient when you are hunting for overstatement.
Statistical against nonstatistical
Statistical sampling uses random selection and probability theory, which lets the auditor measure sampling risk numerically. Nonstatistical sampling relies on judgment and cannot quantify that risk. Both are permitted, and both require the same professional judgment about sample size and evaluation. Note that statistical does not mean every item has an equal chance of selection, since monetary unit sampling deliberately weights toward larger balances.
The attribute sampling terms
| Sample deviation rate | Deviations found divided by sample size. Five failures in a hundred items gives 5%. |
|---|---|
| Allowance for sampling risk | A margin added because the sample may not represent the population perfectly. |
| Upper deviation rate | Sample deviation rate plus the allowance. The auditor's estimate of the worst plausible rate in the population. |
| Tolerable rate | The most deviation the auditor can accept and still rely on the control. |
Upper deviation rate > tolerable rate → do not rely, control risk stays at maximum
The two kinds of sampling risk
Every sampling decision can go wrong in two directions, and the exam cares a great deal about which is which, because one threatens the opinion and the other only wastes money.
| Testing | Effectiveness risk, the serious one | Efficiency risk, the expensive one |
|---|---|---|
| Controls | Assessing control risk too low. You rely on a control that does not work, and do too little substantive testing. | Assessing control risk too high. You do more work than necessary. |
| Substantive | Incorrect acceptance. You conclude a balance is fine when it is materially misstated. | Incorrect rejection. You conclude a balance is wrong when it is fine, and investigate for nothing. |
Nonsampling risk is separate. It is the risk of reaching the wrong conclusion for reasons unrelated to the sample: choosing an unsuitable procedure, misinterpreting evidence, missing a deviation that was in front of you. Increasing sample size does nothing for it. Supervision, review and training do.
How does the legal inquiry letter work?
The auditor needs to know about litigation, claims and assessments that could affect the statements. Since management knows about them and lawyers are bound by privilege, the mechanism is deliberate.
Management prepares and sends the letter, at the auditor's request, to the company's external legal counsel. The lawyer then replies directly to the auditor. That structure matters: management must waive privilege for the response to happen, which is why the request has to come from management rather than from the audit firm.
The letter asks counsel to corroborate management's list of pending and threatened litigation, to assess the likelihood of an unfavorable outcome, and to estimate the potential loss.
What the response drives
| Likelihood | Accrue? | Disclose? |
|---|---|---|
| Probable and reasonably estimable | Yes | Yes |
| Probable but not reasonably estimable | No | Yes |
| Reasonably possible | No | Yes |
| Remote | No | No |
Accrual needs both conditions. Probable alone is not enough, and that second row is the one most summaries leave out, which makes it a reliable place for the exam to find people.
Refusal is a scope limitation. If management will not permit the inquiry, or counsel refuses to respond on a matter, the auditor cannot obtain evidence that is available in principle. That is a scope limitation, leading to a qualified opinion or a disclaimer depending on how pervasive the possible effects are. Part four returns to that decision in full.
Where does Maxwell CPA Review fit?
Concessions first. If you want the largest question bank available, that goes to Gleim or UWorld. If your firm sponsors a course, it is usually Becker, and there is no reason to decline something already paid for. If you want adaptive software that scores your readiness, Surgent does that better than I do.
What Maxwell CPA Review does is different, and fieldwork is the clearest case for it. Every other option in this category answers a shortage: more questions, longer explanations, more visuals. Maxwell answers a surplus. There are perhaps two hundred procedures across the balance sheet, and taught as two hundred facts they are unlearnable. Taught as consequences of directional risk, most of them stop needing to be memorized at all.
Here is what is in the AUD section:
| Video lessons | 6 hours |
|---|---|
| Practice MCQs | 750 |
| Task-based simulations | 32 |
| Textbook | 190 pages |
| Study outlines | 60 pages |
| Also included | Final review and a full simulated exam |
Across the whole course: 50 hours of video content, 5,000 practice MCQs and 150 task-based simulations, covering all six sections, FAR, AUD, REG, BAR, ISC and TCP, with no discipline upcharge. Built to the current AICPA Blueprint, with every lecture, textbook and outline created by one CPA who scored 90 or above on every section.
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Frequently asked questions
What is directional risk in auditing?
The predictable direction in which management is inclined to misstate. Assets and equity tend to be overstated and liabilities and expenses understated, because that combination flatters the financial statements. It follows that the primary assertion for assets is existence and for liabilities is completeness.
What is the difference between lapping and kiting?
Lapping is theft, where an employee misapplies successive customer payments to conceal a stolen receipt. Kiting is fraudulent reporting, where a transfer between the company's own bank accounts is recorded as a receipt before the corresponding disbursement, so the same cash appears in both. A bank transfer schedule detects kiting.
Does the auditor count the inventory?
The client counts the inventory. The auditor observes the client's count procedures and independently performs test counts on selected items. Tracing from the floor to the count sheets tests completeness, and from the sheets to the floor tests existence.
When can negative confirmations be used for receivables?
Only when the risk of material misstatement is low, the population consists of many small balances, few exceptions are expected, and recipients are unlikely to disregard the request. All four conditions must hold. Positive confirmations are the default because silence is not treated as agreement.
What is a cutoff bank statement used for?
It covers roughly the first ten days after year-end and is sent by the bank directly to the auditor. It shows whether outstanding checks and deposits in transit on the year-end reconciliation actually cleared afterwards, which reveals fictitious reconciling items.
What is the difference between attribute and variable sampling?
Attribute sampling is used for tests of controls and measures a rate of deviation. Variable sampling is used for substantive tests of details and measures a dollar amount. Attribute answers come as percentages, variable answers as misstatements.
When is a contingent loss accrued rather than disclosed?
Accrual requires that the loss is both probable and reasonably estimable. Probable but not estimable is disclosed only, as is reasonably possible. Remote requires neither accrual nor disclosure.
Who sends the legal inquiry letter?
Management sends it, at the auditor's request, because privilege must be waived by the client. The attorney responds directly to the auditor. If management refuses to permit the inquiry, or counsel refuses to respond, that is a scope limitation.
Ready for part four?
Part four covers audit reports and the four opinions, going concern, subsequent events and management representations. In the meantime, start with the 2026 AICPA released questions and the free study outline.
Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 90 on AUD and a 95 on FAR. He is the founder and sole instructor of Maxwell CPA Review, where he creates every lecture, textbook and study outline himself.
Reach him at MaxwellCPAreview@gmail.com.
Explore the Complete AUD 101 Series
The foundation of the audit, from engagement letters to initial strategy.
Master the audit risk formula, materiality, and the framework that drives procedures.
A complete walkthrough of the balance sheet, sampling, and the legal letter.
Concluding the audit, handling subsequent events, and issuing the final report.