In the context of an audit of financial statements, substantive procedures are audit procedures that

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By Indeed Editorial Team

Published April 26, 2021

An audit assesses the level of control risk, inherent risk and accuracy in financial records. Most audits include some form of substantive testing, which checks for errors and material misstatements. These substantive auditing methods review, test and analyze a company's financial records. In this article, we discuss what substantive testing is, what happens when substantive testing finds an error, who does substantive testing, how substantive testing works, list some examples of substantive testing and answer frequently asked questions about substantive testing.

What is substantive testing?

Substantive testing is an auditing technique that checks for any errors or material misstatements in a company's accounts, financial statements or supporting documents. When a company claims that their financial records are accurate, complete and valid, substantive testing supports this claim as evidence that there are no errors. This traditional auditing method also helps an auditor to form an overall opinion about the company's financial statements. Substantive testing includes a wide variety of different auditing procedures and tests that an auditor can use depending on the situation.

Related: Audit: Definition, Types and Benefits

Who does substantive testing?

Either a company's internal audit staff or hired external auditors can conduct substantive testing for a company. Using the company's internal audit staff may provide confirmation for whether their internal record systems are performing correctly. If the internal record systems are not performing properly, the internal audit staff can improve the system or eliminate the problem, so the company performs better in the next audit. Internal auditors typically conduct substantive testing at regular intervals throughout the year. External auditors often get hired to conduct substantive testing once a year, usually at the end of the year.

Related: Learn About Being an Internal Auditor

How do substantive tests work?

Here are the steps for how substantive auditing works:

1. A company makes assertions

A company's management team makes implicit or explicit claims about their financial situation, and these auditing assertions get presented to an auditor. There are five general categories of assertions that companies make during audits, which are:

• Occurrence or existence: This assertion states that financial statements listing assets, liabilities and shareholder equity exist when the accounting period is over.

• Disclosure and presentation: This is an assertion that the financial statements will include and present all financial information and financial disclosures in a clear manner that auditors can easily understand.

• Obligations and rights: This assertion states that the company has usage rights or ownership of all the assets listed in the financial statements and that all liabilities belong to the company, not a third party.

• Accuracy or valuation: This assertion states that all the calculations in the financial statements are accurate, classified appropriately and based on a proper valuation of balances, liabilities and assets.

• Completeness: An assertion that the financial statements include and present all the required items, transactions and inventory, including third parties with temporary possession.

2. The auditor creates a plan

The auditor creates a structured audit plan for the company based on the assertions. The auditor identifies which auditing processes, including substantive tests, will best determine any errors or misstatements in the assertions. Categories of auditing processes that auditors can choose include analytical procedures, inquiry and confirmation, inspection, observation and recalculation. For example, to evaluate fixed assets, an auditor could observe a procedure and then analyze the paper records for accuracy.

There are three general activities that an auditor includes in their audit plan for substantive testing, which are:

• Examine physical adjustments and journal entries the company made while the company prepared the financial statements.

• Match the underlying accounting records with the company's financial statements and their supporting documents.

• Test the different classes of account balances, transactions and disclosures.

3. An auditor shares audit results with a company

The auditor writes an official report listing any errors or material misstatements that the audit found, shares the report with management and requests further audit testing if it's warranted. The auditor also provides their overall opinion about the company's financial statements.

Related: Auditing Skills: Definition and Examples

What happens when substantive testing finds an error?

If an auditor finds any errors in a company's financial statements or the supporting documents, the auditor may require the company to do further audit testing. The auditor writes a management letter with a summary of the errors they found and shares the letter with the company and the audit committee. Usually, there are only errors or misstatements if:

• External auditors don't detect an error during audit procedures, which is called detection risk.

• Internal auditors or the internal record systems don't identify or fix an error, which is called control risk.

• The company or auditor doesn't detect initial errors when the financial process and reporting begin.

Related: Guide To Operational Auditing: Definition, Process, Advantages and Disadvantages

Examples of substantive testing

Each substantive procedure should have enough documentation that it allows for collection, review and repetition. The documentation should be thorough enough that more than one auditor can independently test for accuracy and come to the same conclusion. Here is a list of common substantive auditing procedures and tests that auditors do:

• Verify that approved dividends exist by reviewing board minutes from the board of directors

• Confirm that the balances in accounts payable are correct by contacting suppliers

• Confirm that the balances in accounts receivable are correct by contacting customers

• Check that assets obtained from a business combination have fair values assigned to them by confirming with experts

• Watch the physical inventory count as it happens for each ending period

• Test ending cash balances by issuing a bank confirmation

• Contact lenders to confirm that loan balances are correct

• Take fixed asset records and physically match them to fixed assets

• Use inventory valuation calculations to confirm if inventory is valid

• Recalculate the calculations that were already made by the client

• Re-perform a company's procedures to make sure they perform as planned

• Confirm loan balances are correct by contacting lenders

• Test end cash balances by getting bank confirmation

Related: 15 Types of Audits

Substantive testing FAQs

Here are some frequently asked questions about substantive testing:

Does substantive testing take a long time?

Depending on the type and size of the business, substantive testing can be a large and time-consuming process.

How effective is substantive testing?

There is a component of human bias or human error with substantive testing, including a risk of accidental oversight or accidentally missing a material misstatement. However, substantive testing can be more effective when done in conjunction with other approaches. Auditors can also increase effectiveness by using a larger sample size, changing test timing or testing over a larger period of time.

How are substantive tests designed?

Based on the assertion, an auditor determines the nature, extent and timing of the tests to make sure they meet an acceptable level of risk detection. Here is more information about the nature, extent and timing of substantive tests:

• Nature: This refers to the effectiveness and type of auditing procedure that an auditor performs based on the acceptable level of risk. If the level of risk detection is low, the procedures are more costly and effective. If the level of risk detection is high, the procedures are less costly and effective.

• Extent: This refers to the amount of evidence an auditor gathers by adjusting the manner used to conduct substantive tests. If the level of risk detection is low, the procedures typically need more evidence and bigger sample sizes. If the level of risk detection is high, the procedures typically need less evidence and smaller sample sizes.

• Timing: This refers to the how timing can affect the acceptable level of risk. If the level of risk detection is low, the auditor typically performs procedures near or at the balance sheet date. If the level of risk detection is high, the auditor performs procedures near or at the end of the year.

What is substantive procedures in auditing?

How substantive audit procedures are performed by the auditor in an audit of financial statements?

When planning substantive audit procedures What should the auditor do?

When analytical procedures are performed during substantive testing they are typically?