Which of the following is a substantive test of transaction?

The substantive test is the process of obtaining audit evidence and checking the accounting system’s completeness, accuracy, and validity of data.

• Meaning of Substantive Tests
• Types of Substantive Procedures
• Designing Substantive Tests
• Special Considerations in Designing Substantive Tests
• Developing Audit Programs for Substantive Tests
• Difference between Tests of Controls and Substantive Tests

Meaning of Substantive Tests

Substantive procedures (or substantive tests) are those activities performed by the auditor during the substantive testing stage of the audit that gather evidence as to the completeness, validity, and/or accuracy of account balances’ and underlying classes of transactions.

Account balances and underlying transaction classes must not contain material misstatements. They must be materially complete, valid, and accurate.

Auditors gather evidence about these assertions by undertaking substantive procedures, which may include:

• Physically examining inventory on balance date as evidence that inventory shown in the accounting records exists (validity assertion);
• Arranging for suppliers to confirm in writing the details of the amount owing at the balance date as evidence that accounts payable is complete (completeness assertion); and
• Making management inquiries about the collectibility of customers’ accounts as evidence that trade debtors are accurate in their valuation.

Evidence that an account balance or transaction class is not complete, valid or accurate is evidence of a substantive misstatement.

Substantive procedures are designed to obtain audit evidence regarding the completeness, accuracy, and validity of data produced by the accounting system.

The accounting system of an organization generates various data concerning various transactions. Their effect is reflected in the profit and loss account and balance sheet.

These transactions communicate one or more of the following assertions in financial statements.

1. Existence: that an asset/liability exists.
2. Rights and obligations: the enterprise has a right over the asset or has an obligation over the liability.
3. Occurrence: that a transaction happened during the period, say, sales of so many Dollars occurred.
4. Completeness: all transactions/assets/liability find a place in financial statements without omission.
5. Valuation: the monetary values attached to asset or liability are correct or fair.
6. Measurement: that a transaction is recorded in a proper amount. Revenue or expense is properly allocated to the period, e.g., prepaid expense, accrued income. E.g., freight paid to bring machinery is included in the transaction about installation.
7. Disclosure: data is disclosed according to accounting convention, a statutory requirement.

These seven assertions of financial data may be correct or not.

A financial statement may depict a leasehold right as a freehold right. The auditor has to check to ensure that these assertions are fairly represented in the financial statements.

To do this, he performs a substantive procedure.

Types of Substantive Procedures

There are two categories of substantive procedures;

1. Analytical Procedures
2. Tests of Details
   1. Substantive tests of transactions
   2. Tests of details of account balances and disclosures focus.

These are explained below;

1. Analytical Procedures

Analytical procedures are an important part of the audit process and consist of evaluations of financial information made by a study of plausible relationships among both financial and non-financial data.

Analytical procedures range from simple comparisons to complex models involving many relationships and elements of data.

In the audit planning phase, analytical procedures serve as attention-directing devices.

Auditors use them to help determine their substantive procedures’ nature, timing, and extent.

Analytical procedures are used in this phase to increase the auditor’s understanding of the client and identify specific audit risks by considering unusual or unexpected balances or relationships in aggregate data.

Analytical procedures used in planning the audit might include the following:

• Account balance comparison of unadjusted trial balance amounts with adjusted tried balance amounts of the prior year.
• Computation of significant ratios.
• Compare current year ratios to current industry ratios and prior year computing ratios.
• Computation of ratios using nonfinancial and financial data. E.g., sales per square foot of sales space.
• Regression analysis.

2. Tests of Details

Tests of details are usually categorized into two types:

1. Substantive tests of transactions

Test for errors or fraud in individual transactions. Substantive transaction tests emphasize verifying transactions recorded in the journals and then posted in the general ledger.

EX: An auditor may examine a large purchase of inventory by testing that the cost of the goods included on the invoice is properly recorded in the inventory and accounts payable accounts.

2. Tests of details of account balances and disclosures focus.

Tests of details of account balances and disclosures focus on the items that are contained in the financial statement- account balances and disclosures. Tests of details of balances consider the closing balances in the general ledger.

Ex: The auditor may want to test accounts payable by examining a sample of individual invoices that make up the ending balance of accounts payable.

Designing Substantive Tests

Substantive tests provide evidence about the fairness of each significant financial statement assertion.

Conversely, tests may reveal monetary errors or misstatements in the recording or reporting transactions and balances.

Designing substantive tests involves determining the nature, timing, and extent of the tests necessary to meet the acceptable level of detecting risk for each assertion.

1. Nature
2. Timing
3. Extent

1. Nature

The nature of substantive tests refers to the type and effectiveness of the auditing procedures. When the acceptable level of detection risk is low, the auditor must use more effective and usually more costly procedures.

When the acceptable level of detection risk is high, less effective and less costly procedures can be used.

The three types of substantive tests are analytical procedures, a test of details of transactions, and tests of details of balances.

2. Timing

The acceptable level of detection risk may affect the timing of substantive tests. If detection risk is high, the test may be performed several months before the end of the year.

In contrast, when the detection risk for an assertion is low, the substantive tests will ordinarily be performed at or near the balance sheet date.

3. Extent

More evidence is needed to achieve a lower acceptable level of detection risk than a high one. The auditor can vary the evidence obtained by changing the extent of substantive tests performed.

The extent used in practice means the number of items or sample sizes to which a particular test or procedure is applied.

Special Considerations in Designing Substantive Tests

Some special considerations relevant to designing substantive tests for selected types of accounts are:

1. Income Statement Accounts
   1. Analytical procedures for income statement accounts
   2. Test of details for income statement accounts
2. Accounts Involving Accounting Estimates
3. Accounts Involving Related Party Transactions

1. Income Statement Accounts

Traditionally, tests of details of balances have focused more on financial statement assertions that pertain to balance sheet accounts than on income statement accounts.

This approach is efficient and logical because each income statement account is inextricably linked to one or more balance sheet accounts.

Examples include the following:

Balance Sheet AccountBelated Income Statement AccountAccounts receivableSalesInventoriesCost of salesPrepaid expensesVarious related expensesInvestmentsInvestment IncomePlant assetsDepreciation expenseIntangible assetsAmortization expenseAccrued payablesVarious related expensesInterest-bearing liabilitiesInterest expense

Because of these relationships, as compared with substantive tests of balance sheet accounts, tests of income statement accounts rely more heavily on analytical procedures and less on tests of details.

1. Analytical procedures for income statement accounts

Analytical procedures can be a powerful tool for obtaining audit evidence about income statement balances.

This type of substantive testing may be used directly or indirectly. Examples include the following.

AccountAnalytical proceduresHotel room revenueNumber of rooms x Occupancy rate x Average room rate.Wages expenseAn average number of employees per pay period x Average pay per period x Number of pay periods.

2. Test of details for income statement accounts

When the evidence obtained from analytical procedures and test of details of related balance accounts does not reduce detection risk to an acceptably low level, direct tests of details of assertions about income statement accounts are necessary.

This may be the case when.

• Inherent risk is high.
• Control risk is high.
• Analytical procedures reveal unusual relationships and unexpected fluctuations.
• The account requires analysis.

2. Accounts Involving Accounting Estimates

An accounting estimate approximates a financial statement element, item, or account without exact measurement.

Examples include periodic depreciation, the provision for bad debts, and warranty expense.

Management is responsible for establishing the process and controls for preparing accounting estimates.

Judgment is required in making an accounting estimate. Accounting estimates may have a significant effect on a company’s financial statements.

SAS 57, Auditing Accounting Estimates, states that the auditor’s objective in evaluating accounting estimates is to obtain sufficient competent evidential matter to provide reasonable assurance that

• All accounting estimates that could provide the material to the financial statements have been developed.
• The accounting estimates are reasonable in the circumstances.
• The accounting estimates are presented in conformity with applicable accounting principles and are properly disclosed.

In determining whether all necessary estimates have been made, the auditor should consider the industry in which the entity operates, its methods of conducting business, and new accounting pronouncements.

3. Accounts Involving Related Party Transactions

The auditor should identify related party transactions in audit planning.

These transactions concern the auditor because they may not be executed on an arms-length basis.

The auditor’s objective in auditing related party transactions is to obtain evidential matter regarding the purpose, nature, and extent of these transactions and their effect on the financial statements. The evidence should extend beyond the inquiry of management.

In auditing related party transactions, the auditor is not expected to determine whether a particular transaction would have occurred if the parties had not been related or what the exchange price and terms would have been.

The auditor must determine the substance of the related party transactions and their effects on the financial statements.

Developing Audit Programs for Substantive Tests

An audit program is a list of audit procedures to be performed.

The procedures are generally not listed by assertion or specific audit objective to avoid the multiple listing of procedures that apply to more than one assertion or objective.

Which of the following is a substantive test?

What are substantive tests of transactions in auditing?

What are the two types of substantive tests?

Which of the following is an example of a substantive procedure?