The accounting department is the backbone of any business, responsibly analyzing, recording, and reporting financial transactions. Substantive tests are one of the many tools used in the accounting section of a business.
Also popularly called substantive procedures, the auditor uses these tests during the testing stage of the audit. They help gather evidence toward the validity, completeness, and accuracy of the account balances.
Why is it done?
Accounting is a complex process and has to be performed by qualified professionals. Only then are there fewer chances of errors and misstatements in the final records.
The idea behind substantive tests is to ensure no misstatements in the company’s financial accounts. Auditors examine general entries, test account balances, and check other adjustments that may have been made while preparing the financial statements.
Sometimes, they may need to make inquiries about suspicious transactions. For instance, they may externally confirm the account balance by contacting the bank directly. They may also perform a physical inventory check to verify the accounts payable from creditors to the company.
Types of substantive tests
There are two primary types of substantive tests that auditors use regularly. Here’s a brief explanation of what both of these varieties mean.
Test of details
Under this type of procedure, auditors are required to collect evidence that can help them evaluate the correctness of the accounts. They will check the balances, disclosures, and all other accounting transactions made by the company in their financial statements.
Moreover, they make a detailed check of all individual transactions to find any errors or misreporting of facts. To cite an example, an auditor may check a large purchase in the inventory by examining if the cost of the goods recorded in the invoice is the same as in the inventory and accounts payable statements.
These procedures are a critical part of auditing in all types of firms. Through analytical methods, auditors evaluate the financial statements made by examining the plausible relationships between financial and non-financial data. The professionals may perform this test via simple tests or use complex models that involve elements of data.
Some specific things an auditor will do via analytical procedures include the following.
- Regression analysis
- Compute significant ratios
- Comparison of current ratios to prior year ratios and industry ratios
- Account balance comparison by thoroughly checking unadjusted trial balance amount against previous year’s unadjusted trial balance amounts.
What goes into designing these tests?
The following considerations are crucial to designing substantive procedures.
The timing of substantive tests is critical and is determined by the acceptable level of detection risk. So, if the detection risk is very high, the test is typically performed many months before the year-end. Otherwise, they can be done close to the balance sheet date.
In this context, nature refers to the type and effectiveness of auditing. If the acceptable detection risk level is high, auditors must use less expensive and less effective procedures and vice versa.
An auditor needs more evidence to achieve a lower acceptable level of detection risk than a higher one. Consequently, they can change the amount of evidence obtained by changing the extent of the tests performed.
The points mentioned above are fundamental when it comes to designing substantive tests. Special considerations are made in select accounts such as income statements, accounting estimates, and more.
A happy mom, professional article writer, SEO practitioner, blogger, guest blogger & freelancer. She’s in digital marketing since 2018. She loves reading books and spend time with her family. Reach her on Email