Substantive procedures (or substantive tests) are those activities performed by the auditor during the substantive testing stage of the audit that gather evidence as to the completeness, validity and/or accuracy of account balances’ and underlying classes of transactions.
Account balances and underlying classes of the transaction must not’ contain any material misstatements. They must be materially complete, valid, and accurate. Auditors gather evidence about these assertions by undertaking substantive procedures, which may include:
- physically examining inventory on balance date as evidence that inventory shown in the accounting records exists (validity assertion);
- arranging for suppliers to confirm in writing the details of the amount owing at balance date as evidence that accounts payable is complete (completeness assertion); and
- making inquiries of management about the collectibility of customers’ accounts as evidence that trade debtors are accurate as to its valuation.
Evidence that an account balance or class of transaction is not complete, valid or accurate is evidence of a substantive misstatement.
Substantive procedures are designed to obtain audit evidence as to completeness, accuracy, and validity of data produced by the accounting system.
The accounting system of an organization generates various data concerning various transactions. Their effect is reflected in the profit and loss account and balance sheet.
These transactions communicate one or more of the following assertions in financial statements viz.
- Existence: that an asset/liability exists.
- Rights and obligations: that the enterprise has right over the asset or has an obligation over the liability.
- Occurrence: that a transaction happened during the period say, sales of so many Dollars occurred.
- Completeness: that all transactions/asset/liability find a place in financial statements without omission.
- Valuation: the monetary values attached to asset or liability is correct or fair.
- Measurement: that a transaction is recorded in a proper amount. E.g., freight paid to bring machinery is included in the transaction about installation. Revenue or expense is properly allocated to the period, e.g., prepaid expense, accrued income.
- Disclosure: data is disclosed according to accounting convention, a statutory requirement.
These seven assertions of financial data may be correct or not.
A financial statement may depict a leasehold right as a freehold right. The auditor has to check to get assurance that these assertions are fairly represented in the financial statements.
To do this, he performs a substantive procedure.
Types of Substantive Procedures
There are two categories of substantive procedures;
- Analytical procedures; and
- Tests of details.
These are explained below;
1. Analytical Procedures
Analytical procedures are an important part of the audit process and consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data.
Analytical procedures range from simple comparisons to the use of complex models involving many relationships and elements of data.
In the audit planning phase, analytical procedures serve as attention directing device.
The objective of using analytical procedures in this phase is to increase the auditor’s understanding of the client and identify specific audit risks by considering unusual or unexpected balances or relationships in aggregate data.
Analytical procedures used in planning the audit might include the following:
- Account balance comparison unadjusted trial balance amounts with adjusted tried balance amounts of the prior year.
- Computation of significant ratios.
- Compare current year ratios to current industry ratios and prior year computing ratios.
- Computation of ratios using nonfinancial and financial data. E.g., sales per square foot of sales space.
- Regression analysis.
2. Tests of Details
Tests of details are usually categorized into two types:
Substantive tests of transactions
test for errors or fraud in individual transactions. Substantive tests of transactions emphasize the verification of transactions recorded in the journals and then posted in the general ledger.
EX: An auditor may examine a large purchase of inventory by testing that the cost of the goods included on the invoice is properly recorded in the inventory and accounts payable accounts.
Tests of details of account balances and disclosures focus.
Tests of details of account balances and disclosures focus on the items that are contained in the financial statement- account balances and disclosures. Tests of details of balances consider the closing balances in the general ledger.
Ex: The auditor may want to test accounts payable by examining a sample of individual invoices that make up the ending balance of accounts payable.
Designing Substantive Tests
Substantive tests provide evidence about the fairness of each significant financial statement assertion.
Conversely, tests may reveal monetary errors or misstatements in the recording or reporting of transactions and balances.
Designing substantive tests involves determining the nature, timing, and extent of the tests necessary to meet the acceptable level of detecting risk for each assertion.
The nature of substantive tests refers to the type and effectiveness of the auditing procedures to be performed. When the acceptable level of detection risk is low, the auditor must use more effective and usually more costly procedures.
When the acceptable level of detection risk is high, less effective and less costly procedures can be used.
The three types of substantive tests are analytical procedures, a test of details of transactions, and tests of details of balances.
The acceptable level of detection risk may affect the timing of substantive tests. If detection risk is high, the test may be performed several months before the end of the year.
In contrast, when detection risk for an assertion is low, the substantive tests will ordinarily be performed at or near the balance sheet date.
More evidence is needed to achieve a low acceptable level of detection risk than a high detection risk. The auditor can vary the amount of evidence obtained by changing the extent of substantive tests performed.
The extent has used the practice to mean the number of items or sample sizes to which a particular test or procedure is applied’.
Special Considerations in Designing Substantive Tests
Some special considerations relevant to designing substantive tests for selected types of accounts are:
- Income statement accounts.
- Accounts involving accounting estimates.
- Accounts involving related party transactions.
These are explained below;
1. Income Statement Accounts
This approach is both efficient and logical because each income statement account is inextricably linked to one or more balance sheet accounts.
Examples include the following:
|Balance Sheet Account||Belated Income Statement Account|
|Inventories||Cost of sales|
|Prepaid expenses||Various related expenses|
|Plant assets||Depreciation expense|
|Intangible assets||Amortization expense|
|Accrued payables||Various related expenses|
|Interest-bearing liabilities||Interest expense|
Because of these relationships, as compared with substantive tests of balance sheet accounts, tests of income statement accounts rely more heavily on analytical procedures and less on tests of details.
Analytical procedures for income statement accounts
Analytical procedures can be a powerful audit tool in obtaining audit evidence about income statement balances.
This type of substantive testing may be used directly or indirectly. Examples are including the following.
|Hotel room revenue||Number of rooms x Occupancy rate x Average room rate.|
|Wages expense||An average number of employees per pay period x Average pay per period x Number of pay periods.|
Test of details for income statement accounts
When the evidence obtained from analytical procedures and test of details of related balance accounts does not reduce detection risk to an acceptably low level, direct tests of details of assertions about income statement accounts are necessary.
This may be the case when.
- Inherent risk is high.
- Control risk is high.
- Analytical procedures reveal unusual relationships and unexpected fluctuation.
- The account requires analysis.
2. Accounts Involving Accounting Estimates
An accounting estimate is an approximation of a financial statement element, item, or account in the absence of exact measurement.
Examples include periodic depreciation, the provision for bad debts, and warranty expense.
Management is responsible for establishing the process and controls for preparing accounting estimates.
Judgment is required in making an accounting estimate. Accounting estimates may have a significant effect on a company’s financial statements.
SAS 57, Auditing Accounting Estimates, states that the auditor’s objective in evaluating accounting estimates is to obtain sufficient competent evidential matter to provide reasonable assurance that
- All accounting estimates that could provide the material to the financial statements have been developed.
- The accounting estimates are reasonable in the circumstances.
- The accounting estimates are presented in conformity with applicable accounting principles and are properly disclosed.
In determining whether all necessary estimates have been made, the auditor should consider the industry in which the entity operates, its methods of conducting business, and new accounting pronouncements.
3. Accounts Involving Related Party Transactions
The auditor should identify related party transactions in audit planning.
These types of transactions are a concern to the auditor because they may not be executed on an arms-length basis.
The auditor’s objective in auditing related party transactions is to obtain evidential matter as to the purpose, nature, and extent of these transactions and their effect on the financial statements. The evidence should extend beyond the inquiry of management.
In auditing identified related party transactions, the auditor is not expected to determine whether a particular transaction would have occurred if the parties had not been related or what the exchange price and terms would have been.
The auditor is required, however, to determine the substance of the related party transactions and their effects on the financial statements.
Developing Audit Programs for Substantive Tests
An audit program is a list of audit procedures to be performed.
The procedures are generally not listed by assertion or specific audit objective to avoid the multiple listing of procedures that apply to more than one assertion or objective.
In addition to listing audit procedures, each audit program should have columns for;
- cross-reference to other working papers containing the evidence obtained from each procedure,
- the initials of the auditor who performed each procedure, and
- the date performance of the procedure was completed.
In any case, audit programs should be sufficiently detailed to provide:
- An outline of the work to be done.
- A basis for coordinating, supervising, and controlling the audit.
- A record of the work performed.
Difference between Tests of Controls and Substantive Tests
|Points||Test of controls||Substantive tests|
|Definition||Audit procedures performed to test the operating effectiveness of controls in preventing or detecting material misstatements at the relevant assertion level.||Procedures used during accounting audits to check for errors in balance sheets and other financial documentation.|
|Purpose||Determining the effectiveness of design and operation of internal control structure policies and procedures||Determining fairness of statements assertions.|
|Timing||Primarily during interim work.||Primarily at or near balance sheet date.|
|Types||Concurrent and additional.||The analytical procedure, a test of details of transactions and tests of details of balances.|
|Test measurement||Deviations from control structure policies and procedures.||Monetary errors in transactions and balances.|
|Risk component||Control risk.||Detection risk.|
|Applicable audit procedure||Inquiring, observing, inspecting, reperforming, and computer-assisted audit techniques.||Same as tests of controls plus -analytical procedures, counting, confirming tracing, and vouching.|
|Primary fieldwork standard||Second.||Third.|
|Required by GAAS||No.||Yes.|