What Are Substantive Tests in an Audit?

Substantive tests are procedures an auditor performs to detect material misstatements in a company’s financial statements. These tests gather evidence to support the figures and disclosures, ensuring they are accurate, complete, and valid. Auditors use these procedures to directly examine account balances, individual transactions, and other financial disclosures.

This work is distinct from testing a company’s internal controls, which are systems designed to prevent errors. Instead, substantive testing focuses on the financial data itself, which is the output of those systems.

The Role of Substantive Tests in an Audit

When a company prepares financial statements, its management makes implicit claims about the information, known as financial statement assertions. These assertions, outlined in standards by bodies like the Public Company Accounting Oversight Board, are the specific points an auditor must verify. Key assertions include existence, confirming that assets and liabilities are real, and completeness, ensuring all transactions have been recorded.

Other assertions address valuation, ensuring assets and liabilities are recorded at appropriate amounts, and rights and obligations, confirming the company legally owns its assets and owes its liabilities. Substantive tests are designed to gather direct evidence for each of these assertions. For example, to test the existence of inventory, an auditor might physically observe the company’s stock count.

The extent of substantive testing is influenced by the audit risk model, a framework for managing audit risk. This model considers inherent risk, the natural susceptibility of an account to misstatement, and control risk, the risk that internal controls will fail to prevent or detect a misstatement. If an auditor assesses control risk as high due to weak controls, they must perform more extensive substantive testing to compensate for the increased risk.

Primary Categories of Substantive Procedures

Substantive procedures are divided into two main categories: tests of details and substantive analytical procedures. Tests of details involve examining the individual items that make up an account balance or class of transactions. This method is used when auditors need a high degree of certainty about a particular account.

Tests of details include tests of transactions and tests of balances. Tests of transactions verify individual debits and credits are valid and recorded correctly, such as by examining sales invoices for a sample of transactions. Tests of balances focus on verifying an account’s ending balance, like confirming the total accounts receivable with a company’s customers.

The second category, substantive analytical procedures, involves evaluating financial information by studying plausible relationships among both financial and non-financial data. Instead of looking at individual transactions, these procedures assess the reasonableness of account balances at a higher level. For example, an auditor might compare a company’s gross profit margin to industry averages.

These analytical tests identify areas that may require more detailed investigation. If a procedure reveals an unexpected fluctuation, it signals a potential misstatement. For example, if a company’s reported revenue increased by 30% while its cost of goods sold remained flat, an auditor would perform additional procedures to understand this unusual trend.

Common Substantive Testing Techniques

Auditors use several techniques to execute their substantive tests and gather sufficient evidence.

• Physical examination involves the auditor inspecting or counting a tangible asset, such as observing a company’s year-end inventory count.
• Confirmation involves obtaining a direct written response from a third party to verify information, such as cash balances with banks or accounts receivable with customers. According to PCAOB Auditing Standard 2310, this provides highly reliable evidence because it comes from an independent source.
• Inspection is the examination of records or documents, whether internal or external. An auditor might inspect signed contracts to verify revenue terms or review board meeting minutes for authorization of significant transactions.
• Recalculation consists of checking the mathematical accuracy of documents or records. This can include re-calculating depreciation expense or verifying the accuracy of an invoice.
• Vouching and tracing are two related techniques. Vouching selects an item from financial records and traces it back to a source document to test for existence. Tracing works in the opposite direction, following a source document forward to the financial records to test for completeness.