Substantive Testing - AuditTo form the basis of an opinion on the fairness of the financial statements, the third generally accepted fieldwork standard requires the gathering of sufficient competent evidential matter. Substantive tests are the procedures by which auditors gather this evidential matter. Although the nature, extent, and timing of substantive tests is a matter of professional judgment, effective client internal control is a positive influence. Accordingly, the auditor may decide to decrease the amount of substantive testing, omit certain procedures, and/or schedule interim testing.

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Conversely, weak internal control will likely result in increased substantive testing, the need for additional audit procedures, and/or scheduling testing at or after year-end.

 

What Is Involved In Substantive Testing?

Well, in general, substantive tests include:

  • Tests of transactions
  • Tests of details of account balances
  • Analytical procedures

In testing transactions, the auditor is concerned with tests of:

  • Omitted transactions and account understatement (tracing source documents to the books of entry)
  • Invalid or unsupported transactions and account overstatement (tracing recorded transactions to source documents).

 

In analyzing details of account balances, auditors use professional judgment in determining which accounts to scrutinize. Some of the accounts commonly requiring ‘scrutiny’ are:

  • Repairs and maintenance
  • Fixed assets
  • Officers’ salaries
  • Contributions
  • Travel and entertainment
  • Income tax provisions

 

Analytical procedures include the study and comparison of the relationships between data. This involves the comparison of current period financial information with:

  • Prior period information
  • Expected results
  • Predictable pattern information
  • Intra-industry information
  • Nonfinancial information

 

Next are examples of substantive testing procedure for cash, receivables, inventory and fixed assets balances. Read on…

 

Substantive Tests of Cash Balances

A. Presentation and Disclosure

[1]. Read or review the financial statements to verify proper classification.

[2]. Read or review the financial statements to verify disclosures such as those relating to compensation balances.

[3]. Determine the conformity with GAAP.

 

B. Valuation or Allocation

[1]. Simultaneously count cash on hand and negotiable securities.

[2]. Confirm directly with the bank:

  • Account balances
  • Direct liabilities to bank
  • Contingent liabilities to bank
  • Letters of credit
  • Security agreements under the Uniform Commercial Code
  • Authorized signatures

[3]. Count petty cash fund and reconcile with vouchers.

 

C. Completeness

[1]. Obtain bank cutoff statement and determine propriety of year-end outstanding checks and deposits-in-transit.

[2]. Examine or prepare year-end bank reconciliation.

[3]. Prepare a proof of cash.

[4]. Perform analytical procedures.

 

D. Existence or Occurrence (See Valuation or Allocation)

 

E. Rights and Obligations

[1]. Read minutes of the board of directors’ meetings.

[2]. Determine existence of compensating balances, levies, etc.

[3]. Verify names on accounts through confirmation requests.

 

F. Related Income Statement Effects

 

Substantive Tests of Receivable Balances

A. Presentation and Disclosure

[1]. Determine appropriate classification of account balances.

[2]. Read or review the financial statements in order to verify disclosure of:

  • Restrictions—pledging, factoring and discounting
  • Related party transactions

[3]. Trace amounts on trial balance to general ledger control accounts and subsidiary ledger totals.

 

B. Valuation or Allocation

[1]. Confirm account balances where reasonable and practicable using positive and/or negative confirmation requests.

[2]. Examine collections in the subsequent period cash receipts journal.

[3]. Examine and verify amortization tables.

[4]. Examine aging schedules.

[5]. Review adequacy of allowance for doubtful accounts.

[6]. Review collectibility by checking credit ratings (e.g., Dun and Bradstreet ratings).

[7]. Verify clerical accuracy and pricing of sales invoices.

[8]. Foot daily sales summaries and trace to journals.

[9]. Perform tests for omitted and invalid (or unsupported) transactions with respect to subsidiary ledger account balances.

 

C. Completeness

[1]. Perform sales and sales return cutoff tests.

[2]. Perform analytical procedures.

[3]. Test for omitted transactions.

 

D. Existence or Occurrence

[1]. Inspect note agreements.

[2]. Confirm accounts receivable and notes receivable balances.

[3]. Review client documentation.

 

E. Rights and Obligations

[1]. Read minutes of board of directors’ meetings.

[2]. Read leases for pledging agreements.

[3]. Determine pledging and contingent liabilities to bank by using a standard bank confirmation.

 

F. Related Income Statement Effects

[1]. Review installment sales profit recognition.

[2]. Verify accuracy of sales discounts and term discounts.

[3]. Review bad debt expense computations.

[4]. Recalculate interest income on notes receivable.

 

Substantive Tests of Inventory

A. Presentation and Disclosure

[1]. Read or review the financial statements to verify footnote disclosure of:

  • Valuation method and inventory flow, e.g., lower-of-cost-or-market value, first-in-firstout
  • Pledged inventory
  • Inventory in or out on consignment
  • Existence of and terms of major purchase commitments

 

B. Valuation or Allocation

[1]. Verify the correct application of lower-of-cost-or-market value.

[2]. Recalculate inventory valuation under the full absorption costing method.

[3]. Verify the quality of inventory items.

[4]. Vouch and test inventory pricing.

[5]. Perform analytical procedures.

[6]. Verify the propriety of inventory flow.

[7]. Consider using the services of a specialist to corroborate the valuation of inventory (e.g., a gemologist to corroborate the valuation of precious stones).

 

C. Completeness

[1]. Perform cutoff tests for purchases, sales, purchase returns, and sales returns.

[2]. With respect to tagged inventory, perform tests for omitted transactions and tests for invalid transactions.

[3]. Verify the clerical and mathematical accuracy of inventory listings.

[4]. Reconcile physical inventory amounts with perpetual records.

[5]. Reconcile physical counts with general ledger control totals.

 

D. Existence or Occurrence

[1]. Observe client inventory counts.

[2]. Confirm inventory held in public warehouses.

[3]. Confirm existence of inventory held by others on consignment.

 

E. Rights and Obligations

[1]. Determine existence of collateral agreements.

[2]. Read consignment agreements.

[3]. Review major purchase commitment agreements.

[4]. Examine invoices for evidence of ownership.

[5]. Review minutes of the board of directors’ meetings.

 

F. Related Income Statement Effects

[1]. Verify that ending inventory on the balance sheet is identical to ending inventory in the Cost of Goods Sold section.

 

Substantive Tests for Fixed Assets

A. Presentation and Disclosure

[1]. Read the financial statements in order to verify:

  • Disclosure of historical cost
  • Disclosure of depreciation methods under GAAP
  • Financial statement classification
  • Disclosure of restrictions

 

B. Valuation or Allocation

[1]. Examine invoices.

[2]. Inspect lease agreements and ascertain the proper accounting treatment (e.g., capital vs. operating lease).

[3]. Analyze repairs and maintenance accounts.

[4]. Analyze related accumulated depreciation accounts.

[5]. Vouch entries in fixed asset accounts.

[6]. Test extensions and footings on client-submitted schedules.

 

C. Completeness

[1]. Perform analytical procedures.

[2]. Inspect fixed assets.

[3]. Examine subsidiary schedules.

[4]. Reconcile subsidiary schedules with general ledger control.

 

D. Existence or Occurrence

[1]. Inspect fixed assets.

[2]. Examine supporting documentation.

 

E. Rights and Obligations

[1]. Inspect invoices.

[2]. Inspect lease agreements.

[3]. Inspect insurance policies.

[4]. Inspect title documents.

[5]. Inspect personal property tax returns.

[6]. Read minutes of the board of directors’ meetings.

 

F. Related Income Statement Effects

[1]. Recalculate depreciation expenses.

[2]. Recalculate gain or loss on disposal of fixed assets.