Substantive procedures in Audit and their Types

We know that an auditor has to collect evidence in support of his opinion. The auditor obtains this audit evidence by using compliance and substantive procedures. While compliance procedures are those tests that seek to examine the efficacy of internal controls operating in the client’s entity, substantive procedures are tests designed to check the accuracy and validity of an account balance, a transaction, or a specific financial statement assertion. Vouching of business transactions and verification of assets and liabilities also form part of substantive procedures.

What are substantive procedures in an audit?

Substantive procedures (also known as substantive tests) are those activities that are performed by an auditor to gather evidence with respect to the completeness, validity, and accuracy of account balances and underlying classes of transactions of the client’s business.

SA 330, “The Auditor’s Responses to Assessed Risks”, defines a substantive procedure as an audit procedure designed to detect material misstatements at the assertion level.

The management of the client’s entity asserts that account balances, as well as transactions, do not contain any material misstatements. It asserts that they are complete, valid, and accurate. But the auditor, before expressing his opinion on the financial statements, has to judge whether the assertions made by the management are true or not. He has to see whether the account balances and underlying classes of transactions of the entity are actually valid and that they are free of any fraud or errors. To do so, he has to gather suitable audit evidence and this evidence is gathered by undertaking activities known as substantive procedures.

Thus, substantive audit procedures are designed to check the validity and correctness of the accounting treatment of transactions. They are performed by the auditor to detect whether there are any material misstatements in the accounting transactions.

Types

Substantive procedures in Audit are divided into two categories:

1. Tests of detail (further divided into two)

• Test of transactions (also called vouching) (e.g., casting, checking of posting, etc.)
• Test of balances (also called verification) (e.g., physical examination, confirmations, etc.)

2. Analytical review procedures

Tests of detail include verification of transactions, account balances, and disclosures in the financial statements. The auditor performs these checks to ensure that financial statements and accompanying notes agree to the information contained in accounting records. It can comprise verification of journal entries and their posting to ledger accounts, examination of source documents, inquiring or overserving an accounting process, verifying the existence and valuation of assets or liabilities, and so on. Thus, tests of detail are a group of all those tests that an auditor performs to be assured about the authenticity of transactions documented in the client’s books.

On the other hand, analytical review procedures do not go into that detail as compared to the tests of detail. Analytical procedures enable an auditor to evaluate financial information based on a study of relationships between different variables of financial & non-financial data. They can range from simple comparisons of current and past year data to the use of complex models involving many relationships and elements of data.

It may be noted that analytical procedures generally provide less reliable evidence as compared to the tests of detail.

Various assertions made by the management

As stated earlier, substantive procedures seek to test the assertions made by management. They help to provide the auditor a reasonable assurance in respect of the following assertions made by management. In other words, one can say that substantive procedures test the following:

1. Existence, i.e., if an asset or liability exists at a particular date.

2. Rights and obligations, i.e., whether an asset is a right of the business and a given liability is an obligation of the business at a particular date.

3. Occurrence, i.e., if a transaction has actually occurred and whether it pertains to the business during the relevant period.

4. Completeness, i.e., whether there are any unrecorded assets, liabilities, or transactions.

5. Valuation, i.e., if an asset or liability is carried at an appropriate value.

6. Measurement, i.e., whether a transaction is recorded in the proper amount, proper account, etc., and whether income or expense is allocated to the proper period.

7. Presentation and disclosure, i.e., if an item has been disclosed and classified in accordance with the required accounting policies/principles and any statutory requirements applicable to the entity.

Examples of substantive procedures

Some examples of substantive procedures undertaken by an auditor can be as follows:

• The auditor physically examines inventory on the balance sheet date to obtain evidence as to the fact that the inventory shown in the accounting records is valid and that it actually exists. (This will verify the “existence” assertion).
• The auditor can arrange for suppliers to confirm from them in writing the details of the amounts owing at the balance sheet date. It provides evidence that the balance of accounts payable is correct and complete.
• The auditor can make inquiries about the collectability of customers’ accounts to ensure that trade debtors are valued accurately. (This will verify the “valuation” assertion).
• The auditor can match customer orders to invoices billed.
• The auditor can also match collected funds to invoices billed.
• He can match material purchase records to inventory on hand or sold.
• He can examine supporting documents of important transactions.
• The auditor can obtain bank confirmations.
• The auditor can confirm debt or the terms of the agreements/contracts from lenders or third parties.
• Similarly, the auditor may make an analytical analysis of the relationship between financial variables such as assets, liabilities, revenue, and expenses.

In the case where an account balance or a class of transactions is found to be invalid, inaccurate, or incomplete, it amounts to evidence of a substantive misstatement.

Compliance procedures

Here, it is pertinent to mention that an auditor also undertakes some audit tests, also known as compliance procedures or tests of controls, which are designed to obtain reasonable assurance regarding the internal control system. These tests seek to test the following assertions:

• Existence, i.e., the internal control system exists.
• Effectiveness, i.e., the internal control system in the company is operating effectively.
• Continuity, i.e., the internal control system has continued to function properly throughout the period under audit.

How do substantive procedures differ from compliance procedures?

We know that auditing procedures are broadly categorized into two parts: compliance procedures and substantive procedures. The below-mentioned points draw a line of distinction between them:

• Meaning:

Compliance procedures are those that assess the reliability of internal controls operating in an entity whereas substantive procedures are those that assess the validity and correctness of transactions as well as account balances. They see whether the accounting treatment of business transactions is correct or not.

• Nature of evidence:

By applying compliance procedures, the auditor can obtain evidence as to whether a misstatement is likely. But by applying substantive procedures, the auditor gets evidence as to whether a misstatement actually exists.

For example, if the compliance procedures reveal that the internal control system of the entity with regard to credit sales is weak, the auditor might think that the credit sales may not be correctly recorded in the profit and loss account. But it is only when the auditor employs substantive procedures that he can come to a conclusion. That is to say, when the auditor traces sales invoices to the accounting records, compares the figures of credit sales with that of the last year, obtains confirmations from debtors, etc., he can conclude whether a misstatement exists and whether the financial statements need adjustment.

• Dependency on one another:

The extent of substantive procedures is somewhat dependent upon the results shown by compliance procedures.  For instance, in the above example, if the compliance procedures reveal that the internal control system related to credit sales is strong and is functioning properly, then the auditor may reduce (but not eliminate) the extent of substantive procedures to be applied to the transactions of credit sales.  

Conclusion

An auditor’s purpose in performing substantive procedures is to ensure that there are no substantial misstatements in the company’s financial records, i.e., that they are complete, accurate, and valid, and that all material information is reported. Testing the account balances, examining the journal entries and other adjustments made while creating the company’s financial statements are all part of the procedures. It also entails conducting inquiries into suspected transactions.

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