Substantive tests performed by the auditor consist of tests of details of transactions and account balances, and analytical procedures. The objective of substantive tests is to detect material misstatements in the financial statements. The auditor selects particular substantive tests to achieve audit objectives and considers, among other things, the risk of material misstatement of the financial statements, including the assessed levels of control risk, and the expected effectiveness and efficiency of such tests [US Statement on Auditing Standard No. 31, “Evidential Matter” 1980]. The evidential matter provided by the combination of the auditor’s assessment of inherent risk and control risk and by substantive tests provides a reasonable basis for the resulting opinion on the fairness of the financial statements.
Through this post, I am going to discuss substantive Auditing Test. Right after this post I am going to post about “audit evidence” and “Concurrent Auditing Techniques” as part of this substantive auditing sequel. Enjoy!
The auditor’s responsibility is to design audit procedures that will provide reasonable assurance that any material misstatements due to errors or irregularities will be detected and removed from the financial statements. Errors are unintentional mistakes including clerical mistakes, mistakes in the application of accounting principles, and misinterpretation of facts. Irregularities result from intentional distortions such as fraud or defalcations. It is important to note that an audit does not include procedures specifically designed to detect illegal acts [Statement on Auditing Standard No. 54, “Illegal Acts by Clients” 1988].
The auditor must collect evidence and document the collection process. Evidence requirements are found in the Third Standard of Fieldwork, which states:
sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit.
More specifically, the evidence is obtained to support or refute the assertions that pertain to the accounts in the financial statements. Financial statement assertions can be classified as follows: existence or occurrence, completeness, rights and obligations, valuation and allocation, and presentation and disclosure.
For evidence to be useful to the auditor it must possess to some degree each of four characteristics: relevance, freedom from bias, objectivity, and persuasiveness. Six types of audit evidence are available to the auditor to support a given audit objective: physical evidence, representations by third parties, mathematical evidence, documentation, representations by client personnel, and data interrelationships.
I will be discussing “Audit Evidence” and “Concurrent Auditing Techniques” in more details shortly as part of this auditing series.
The overall test objective relates either to tests of controls or substantive tests. Tests of controls determine the effectiveness of the design and operation of control structure policies and procedures. The results of these tests assist in determining the nature, timing, and extent of substantive tests. Substantive tests determine if material dollar or disclosure misstatements exist in the financial statements. If the client has established a good internal control structure, the auditor may decide to restrict substantive testing because the client’s internal control structure is likely to prevent or detect material misstatements. This relationship means that if the financial statements are less likely to contain material misstatements, the auditor may properly do less substantive audit work than if the financial statements are likely to contain material misstatements.
Types of Substantive Tests
Substantive tests can be classified as follows:
- analytical tests;
- observation and inquiry;
- tests of transactions; and
- tests of balances.
Analytical tests are evaluations of financial information and nonfinancial data, and may be used as substantive tests. In fact, some audit objectives may be difficult or impossible to achieve without relying to some extent on analytical tests because they may be more effective or efficient than tests of details. For example, analytical tests may be more effective than tests of details in testing the completeness assertion for income statement accounts.
Although not used extensively, inquiry can be used as a substantive test. For example, inquiries regarding subsequent events would be a substantive test because they provide evidence regarding the adequacy of disclosures in the financial statements. Tests of transactions are the auditor’s examination of the documents and accounting records involved in the processing of a specific type of transaction. A substantive objective is accomplished when the purpose of the auditor’s examination is to determine if dollar errors have occurred during the processing of the transaction. Tests of balances are audit tests performed directly on a balance to identify misstatements in an account. Two specific examples of tests of balances are confirmation and observation.
Specific Audit Techniques
The major types of tests can be classified into specific methods to gather evidence as follows:
- Physical Examination – Physical examination is the activity of gathering physical evidence. As a substantive test, it involves the examination of assets that have a tangible existence, such as cash or equipment. Physical examination is an activity used in the observation of inventories. This activity is a generally accepted auditing procedure used as a substantive test. The independent auditor who issues an opinion when he or she has not employed this procedure has the burden of justifying the opinion expressed [Statement on Auditing Standard 1, 1982, “Inventories”]. The primary audit assertion tested by physical examination is existence. However, it also provides evidence about valuation. The completeness assertion may also be tested through physical examination in that items omitted from the financial statements may be discovered.
- Confirmation – The confirmation technique requires the auditor to request a written response from a specific third party about a particular item affecting the financial statements. The primary assertions tested by confirmation are existence and rights and obligations. This technique can also provide evidence about the valuation or allocation, completeness, and presentation and disclosure assertions. The auditor’s decision to use confirmation procedures rather than, or in conjunction with, tests directed toward documents or parties within the entity is based upon a desire to use substantive tests to obtain more or different evidence about a financial statement assertion. For example, confirmation of accounts receivable is a generally accepted auditing procedure that will be performed unless certain conditions are met [Statement on Auditing Standards No. 67, 1991, “The Confirmation Process”].
- Vouching – Vouching is the examination of documents that support a recorded transaction or amount. Because the purpose of the vouching technique is to obtain evidence about a recorded item in the accounting records, the direction of the search for the supporting documents is crucial. The direction of testing is from the recorded item to supporting documentation. Vouching can best provide evidence addressing existence or occurrence, valuation or allocation, rights and obligations, and presentation and disclosure.
- Tracing – Tracing is the following of source documents to their recording in the accounting records. This procedure is performed by selecting source documents and tracing them through the accounting system to their ultimate recording in the accounting records. Tracing is often used as a test of the completeness assertion.
- Re-performance – The re-performance of client activities involved in the accounting process is a common substantive technique. Evidence is obtained about client activities by repeating the activities and comparing the result with the client’s result.
- Reconciliation – Reconciliation is the process of matching two independent sets of records. In an audit, one set of records is usually the client’s and the other set is the third party’s. Reconciliation primarily serves the assertions of completeness and existence or occurrence. The preparation of a bank reconciliation is a common example of this technique.
- Inquiry – Inquiry is a broad audit technique that entails asking questions. Inquiry is used extensively in an audit and as a substantive test it may address any of the assertions.
- Inspection – Inspection is the examination of documents in other than the vouching or tracing techniques. It is the critical reading of a document comparing the information therein with other information known to the auditor or recorded in the accounts. Because of the variety of documents that auditors may inspect, the inspection technique addresses all the financial statement assertions.
- Analytical Procedures – Analytical procedures encompass a number of specific procedures the auditor may perform. Auditors employ specific procedures to assess the reasonableness of data and to identify unusual relationships. Because unusual relationships among data can occur for a number of reasons, analytical procedures may address all five financial statement assertions.
The auditor’s responsibility is to reduce the possibility of audit risk to an acceptably low level. The auditor uses the assessed levels of control risk and inherent risk to determine the acceptable level of detection risk for financial statement assertions. The auditor then uses the acceptable level of detection risk to determine the nature, timing, and extent of substantive procedures to be used to detect material misstatements in the financial statement assertions. It is not appropriate, however, for an auditor to rely completely on the assessments of inherent risk and control risk to the exclusion of performing substantive tests of account balances and classes of transactions where misstatements could exist that might be material when aggregated with misstatements in other balances or classes [US Statement on Auditing Standards No. 47, 1983, “Audit Risk and Materiality in Conducting an Audit”].
As the acceptable level of detection risk decreases, the assurance provided from substantive tests should increase. Consequently, the auditor may do one or more of the following [Statement on Auditing Standard No. 55, 1988, ”Consideration of the Internal Control Structure in a Financial Statement Audit”]:
. change the nature of substantive tests from a less effective to a more effective procedure, such as using tests directly toward independent parties outside the entity rather than tests directed toward parties or documentation within the entity;
. change the timing of substantive tests, such as performing them at year-end rather than at an interim date;
. change the extent of substantive tests, such as using a larger sample size.
In considering efficiency, the auditor recognizes that additional evidential matter that supports a further reduction in the assessed level of control risk for an assertion would result in less audit effort for the substantive tests of that assertion. The auditor weighs the increase in audit effort associated with the additional test of controls that is necessary to obtain such evidential matter against the resulting decrease in audit effort associated with the reduced substantive tests. When the auditor concludes it is inefficient to obtain additional evidential matter for specific assertions, the auditor uses the assessed level of control risk based on the understanding of the internal control structure in planning the substantive tests for those assertions.
Although the inverse relationship between control risk and detection risk may permit the auditor to change the nature or the timing of substantive tests or limit their extent, ordinarily the assessed level of control risk cannot be sufficiently low to eliminate the need to perform any substantive tests to restrict detection risk for all of the assertions relevant to significant account balances or transaction classes. Consequently, regardless of the assessed level of control risk, the auditor should perform substantive tests for significant account balances and transaction classes.
An auditor must determine when to perform each audit procedure [Statement on Auditing Standards No. 47, 1983, “Audit Risk and Materiality in conducting an Audit”]. Audit procedures performed before year-end are known as interim procedures. In deciding whether to perform interim procedures, the auditor should consider the entity’s internal control structure, changing business conditions, the risk associated with the various account balances, and the predictability of account balances at year-end. If interim substantive tests are performed, additional tests must be performed at year-end. Then year-end tests may involve further tests of details or analytical procedures.