Substantive procedures are designed to gather sufficient and appropriate audit evidence to form an opinion on the financial statements' accuracy and reliability. These procedures focus on verifying the amounts and disclosures in the financial statements to ensure they are free from material misstatement, whether due to fraud or error.
Substantive procedures can be broadly categorized into Tests of Details and Analytical Procedures:
1.Tests of Details
Tests of details involve direct examination of financial transactions and account balances. These procedures focus on verifying the individual elements that make up the financial statements. The key types of tests include:
Inspection:
Physically examining documents and records, such as invoices, contracts, and agreements, to confirm the existence, completeness, and accuracy of transactions or balances. For example, inspecting supporting documents for sales transactions to confirm the revenue recorded is legitimate.
Recalculation:
Checking the mathematical accuracy of amounts recorded in the financial statements. This could include recalculating depreciation, interest, or tax provisions to ensure they are correctly calculated.
Confirmation:
Sending direct requests to third parties (e.g., customers, banks, suppliers) to confirm balances or transactions. Common confirmations include verifying bank balances, accounts receivable, or loan agreements.
Observation:
Watching physical processes or counting assets (e.g., inventory counting) to verify existence and condition. This is often used to verify inventory levels or assets in the balance sheet.
Vouching:
Tracing recorded transactions back to the original supporting documents (e.g., invoices or purchase orders) to verify that the transaction was valid and properly recorded.
Tracing:
Following transactions from their source (e.g., sales invoices) through the accounting system to the financial statements. This procedure helps verify completeness and ensures no transactions are omitted.
Cutoff Testing:
Verifying that transactions are recorded in the correct period. For example, confirming that sales or purchases near year-end are recorded in the correct period to prevent errors in the reporting period.
2.Analytical Procedures
Analytical procedures involve evaluating financial information by studying plausible relationships among financial and non-financial data. These procedures are designed to identify unusual patterns or discrepancies that might indicate misstatements.
Comparisons with Prior Periods:
Comparing financial statement balances and ratios (e.g., revenue, gross profit margin, etc.) to those from prior periods to identify significant changes or trends. Substantial deviations could indicate errors or fraudulent activities that need further investigation.
Budget vs. Actual Comparison:
Comparing actual results with budgeted or forecasted figures to identify variances that might require further inquiry or explanation.
Industry Comparisons:
Comparing the entity’s financial ratios (e.g., liquidity, profitability, efficiency) with industry benchmarks to assess whether the entity’s performance aligns with its peers.
Trend Analysis:
Reviewing financial data over multiple periods to identify significant trends, such as increasing debt levels, declining sales, or deteriorating margins, that may indicate misstatements or require further investigation.
Ratio Analysis:
Calculating and analyzing key financial ratios (e.g., current ratio, return on equity, inventory turnover) to assess the reasonableness of account balances and financial position.
Key Considerations for Substantive Procedures
1.Sufficiency of Evidence:
The auditor must gather a sufficient quantity of evidence to support the audit opinion. This is determined by considering the assessed risks of material misstatement, the nature of the audit procedures, and the quality of the evidence obtained.
2.Appropriateness of Evidence:
The evidence must be both relevant (related to the assertion being tested) and reliable (produced by credible sources). Evidence obtained through direct observation, third-party confirmation, and independent recalculation is generally considered more reliable.
3.Materiality:
Substantive procedures focus on areas where material misstatements are likely to occur. Materiality thresholds guide the extent and nature of substantive testing.
4.Risk Assessment:
Based on the auditor’s risk assessment, the substantive procedures chosen will vary in nature and scope. High-risk areas may require more detailed and extensive procedures.
5.Timing of Procedures:
Substantive procedures can be conducted at various stages of the audit. Some procedures may be done during interim periods (e.g., testing controls or transactions), while others are performed near the end of the audit to ensure completeness and accuracy of year-end balances.
Conclusion:
The objective of substantive procedures is to gather audit evidence that supports the auditor’s opinion about the truth and fairness of the financial statements. By combining tests of details with analytical procedures, auditors can obtain comprehensive evidence to address the financial statement assertions (existence, completeness, accuracy, valuation, and presentation). The specific choice of substantive procedures depends on the nature of the entity, its internal controls, the assessed risks of material misstatement, and the auditor's professional judgment.