Substantive Testing

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21 Aug, 2024

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Substantive testing refers to an auditing method that involves checking for material misstatements or errors in a company’s financial statements, accounts, or supporting documents. This conventional auditing technique allows auditors to establish an overall opinion regarding the organization’s financial statements.

When any company claims that its financial records are complete, valid, and error-free, this auditing method can support its claim as proof that no errors exist. The technique includes an extensive range of auditing procedures used by auditors based on the situation. It can be of different types, like analytical procedures and tests of details concerning transactions.

What Is Substantive Testing?

Substantive testing refers to a technique used in auditing to identify fraud or material misstatements at the assertion level. It can help companies verify if the data in their financial statements are accurate.
This technique has three categories or types — analytical procedures, tests of details concerning transactions, and tests of details regarding balances.
A key difference between compliance testing and substantive testing is that the former is utilized by auditors before the latter.
When using this technique during an audit, auditors prepare an audit plan on the basis of five assertions.

Substantive Testing Explained

Substantive testing refers to an audit’s phase in which auditors accumulate samples to spot material misstatements in the accounting records or any other data of their clients.

Auditors use this technique to check whether an organization’s financial records are accurate and valid. They carry out this procedure per the Generally Accepted Accounting Standards (GAAS). Such standards require auditors to comprehend all relevant audit controls. Moreover, they must evaluate if such controls can effectively prevent material misstatements that might appear on a company’s balance sheet.

Typically, errors or misstatements are there in a published financial statement when —

The control or internal audit system does not identify or rectify the mistakes.
Managing financial reporting and process
The external audit fails to spot errors during the audit.

Either hired external auditors or internal audit staff can utilize this technique for any company. Note that if an organization’s internal control systems do not perform accurately, its internal control staff may decide to eliminate the issue or improve the system so that the organization delivers better performance when the next audit takes place. Typically, the internal audit staff of any company uses this method periodically every year. Usually, at the end of an accounting year, companies hire external auditors to utilize this technique.

Steps

Substantive testing in audit involves the following steps:

#1 - The Organization Makes Assertions

In the first step, an organization’s management team makes explicit or implicit claims regarding the financial situation. Such audit assertions are presented to auditors and fall into any of the following categories:

Disclosure And Presentation: It states that a company’s financial statements will present and include every financial disclosure and detail clearly so that auditors can understand easily.
Occurrence Or Existence: It is a declaration regarding the existence of financial statements listing shareholder equity, liabilities, and assets at the end of the accounting period.
Rights And Obligations: Such an assertion specifies that a company has ownership or usage rights of every asset listed in its financial statements. Moreover, it states that the company has all the liabilities.
Completeness: This assertation states that a company’s financial statements present and include every required item, inventory, and transaction.

The last assertion specifies that every calculation in financial statements is correct. Moreover, it states that the classification of all calculations is based on the proper valuation of assets, liabilities, and balances.

#2 - The Auditor Prepares A Plan

In the next step, the auditor creates a well-structured plan based on the above assertions. Typically, auditors include these activities in such a plan:

Matching underlying accounting records of that company with its financial statements and all supporting documents
Testing different account balance classes, disclosures, and transactions
Examining journal entries and physical adjustments made by the organization while preparing its financial statements

The last step involves auditors writing an official report that lists material misstatements or errors identified during the audit. Then, they share that report with management and teams, requesting further audit testing only if it is necessary. Also, the auditor gives an overall opinion regarding the business’s financial statements.

Types

The different types of substantive testing in audit are as follows:

Tests Of Details Regarding Balances: The testing of balances occurs to determine if there is a material misstatement in the account balances of financial statements. It aims to show that substantive tests associated with transactions and tests of control are reasonable.

Tests Of Details Concerning Transactions: The testing of transactions concentrates on individual transactions making up account balances. The test of details occurs to determine the accuracy of transactions in financial statements. Generally, auditors choose a sample to check if the details match a transaction recorded in the books of an organization.

Analytical Procedures: Such procedures compare various operational and financial data sets to determine the consistency of relationships and trends. Such techniques can alert companies regarding potential issues with their financial records, allowing them to investigate the problems further.

Examples

Let us look at a few substantive testing examples to understand the concept better.

Example #1

Suppose Company ABC sells t-shirts to its customers. The organization usually maintains purchasing records to monitor the total products sold and the items left in stock. The internal audit team of the organization conducts substantive testing to compare the total number of products or goods sold with the total items yet to be sold. For example, if the opening stock included 200 t-shirts and the records say that the company sold 100 t-shirts, the technique is used to confirm whether 100 t-shirts remain in the inventory. Tracking the sales allows employees to monitor sales figures accurately.

Example #2

Suppose Company DBC gets its internal audit team at fixed intervals in a year to carry out substantive testing that spots issues related to its accounts receivable. As part of the process, the business makes assertions, and based on those assertions, the auditing team prepares a structured plan to determine misstatements or errors. The plan includes checking the recorded journal entries, reviewing sales contracts, checking the different transaction classes, etc. Lastly, the team shares the results of the audit with Company DBC and gives their overall opinion regarding the financial records.

Substantive Testing vs Control Testing

The meaning and purpose of substantive and control testing can be confusing for individuals new to finance. That said, one can develop a clear understanding of such topics by knowing how they differ. So, let us look at a few key distinct characteristics of such concepts.

Substantive Testing	Control Testing
It involves testing if the information is accurate.	This method helps determine if the management of information takes place under a system promoting accuracy.
This technique directly examines elements of components of a company’s financial statements, like transactions and account balances.	It involves assessing processes and evaluating the internal controls’ success and design.
Generally, auditors use this method when using control testing or afterward.	Auditors use this technique in the early stages of an audit.

Substantive Testing vs Test of Details

When individuals are unfamiliar with the concepts of substantive testing and control testing, they can check their key differences to have a clear understanding of their meaning. The table below shows how they differ.

Substantive Testing	Test of Details
It is a broader term that covers various procedures that ensure financial statements’ reliability.	Test of details involves focusing on individual items in a company’s financial statements.
Such an audit procedure can be qualitative as well as quantitative in nature.	Generally, such tests are quantitative procedures.

Substantive Testing vs Compliance Testing

Understanding substantive and compliance testing can be a challenge at first for one who is not aware of these concepts. Let us find out what are their distinct features:

Substantive Testing	Compliance Testing
Substantive testing involves checking the contents’ integrity.	Compliance testing determines whether controls are present.
This technique aims to collect evidence regarding the validity, completeness, and correctness of the data.	In this case, auditors accumulate evidence with the aim of checking a company’s compliance with all control procedures.
Auditors use this method after compliance testing.	This technique is used before substantive testing.

Frequently Asked Questions (FAQs)

1. What are some errors found via substantive testing?

There are various kinds of errors found through this technique. Let us look at them,
- Clerical Errors: Such errors arise due to incorrect posting.
- Errors of Duplication: These errors occur when businesses record any transaction multiple times.
- Omission Errors: Such errors arise when businesses do not record a transaction in their books of accounts.
- Errors Of Commission: In this case, errors arise due to incorrect recording of the transaction or entry amount.

2. What are some challenges faced when conducting substantive testing?

The potential challenges may be as follows:
- Budget constraints as the technique requires a team of auditors.
- The process itself can be time-consuming.
- There might not be enough technological solutions that can streamline the procedures involved when using the technique.

3. What are substantive testing best practices?

The best practices involve auditors determining the extent, timing, and nature of the test to ensure they meet a risk detection level that is accurate.