Substantive Procedure

What are Substantive Procedures?

Substantive procedures are the method or audit tests designed by an auditor to evaluate the financial statements of the company which require an auditor to create conclusive evidence for verifying the completeness, accuracy, existence, occurrence, measurement, and valuation (audit assertions) of the financial records of the business.

Explanation

The intention behind performing the Substantive procedures by an auditor is to check that there is no material misstatement in the financial records of the business, i.e., they are complete, accurate, valid, and all the material information is disclosed. The method followed includes testing the account balances, examining the general entry, and other adjustments that are made while preparing the financial statement of the companyFinancial Statement Of The CompanyFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more, and it also includes making inquiries about the suspicious transactions. Some of the examples can be external party confirmation like confirming the bank balance of the company from Bank directly, performing a physical inventory count, confirming accounts payableAccounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period.read more from creditors of the business, etc.

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Example of Substantive Procedure

For example, there is a company named BSR Trading, whose financial statements of the company shows the following balances:

Substantive Procedure

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  1. Cash balance of $2,500
  2. The bank balance of $6,000
  3. Accounts receivableAccounts ReceivableAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more balance of $10,000
  4. Trade payable balance of $8,000
  5. InventoryInventoryDirect material inventory, work in progress inventory, and finished goods inventory are the three types of inventories. The raw material is direct material inventory, work in progress inventory is partially completed inventory, and finished goods inventory is stock that has completed all stages of production.read more of $5,000

Now the substantive procedures that can be followed on the above balances are:

  1. The physical verification of cash balance is to be done to check that the balance is accurate.
  2. To verify a bank balance of $6,000, the auditor shall send written mail to the bank of the client to confirm that the balance of the client in the books of a bank is the same as that in the account books of the client and if there are any discrepancies then firstly the bank reconciliation statementReconciliation StatementA reconciliation statement contains a list of differences between bank balance as per bank statement, books of accounts, debtor-creditor reconciliation, debt balance reconciliation, or any other reconciliation with a difference in the records of two separate legal entities, and it aims at nullifying the difference.read more is to be prepared, and if any differences still exist then, the auditor should make the inquiry to find out the difference.
  3. For account receivable balances, the sales invoices should be verified, and also the debtors can be asked to confirm their balances.
  4. For Trade Payable balances, the purchase invoices should be verified, and also the Creditors can be asked to confirm their balances.
  5. To check the balances of inventory purchases, invoices, as well as sales invoices, should be verified, and the physical counting of inventory should be done.

Types

There are two types which are as follows:

Types-of-Substantive Procedure.jpg

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#1 – Test of Details

Test of details refers to the process of collecting evidence that helps in evaluating the correctness of the account balances, disclosures, and other accounting transactions made by the business entity in their financial statements.

#2 – Substantive Analytical Procedures

Analytical procedures are an important method performed while conducting the process of auditing. The analytical procedures, the evaluations are made on the financial statements by studying the plausible relationships between both financial as well as non-financial data. For example, computation of ratios, comparison of past year balances with that of the current year, etc.

Substantive Procedure for Account Transactions

It followed to check the purchases of the raw material of the business:

  1. Firstly the purchase orders and the respective invoices should be verified, and then the invoices are to be matched with the GRN (goods receipt notes) to check that for every purchase invoice, the respective goods have been received.
  2. Rates and the quantity purchased that is there in the purchase orderPurchase OrderA Purchase Order (PO) serves as a legal document between buyer and seller, wherein, the buyer sends this contract that details the goods and services, date of delivery, payment terms as per the contract etc.read more should be the same as the purchase invoice.
  3. Then the posting of items received in the relevant ledger accounts should be verified.
  4. Then the cut-off procedures on the purchases should be performed.
  5. Last but not least, the analytical procedure is to be performed by comparing the purchase trends of last year with the current purchases, and if there is a major difference in the trend, then the reasons for such difference should be found.

The substantive procedure followed to check the Related party transactionRelated Party TransactionRelated party transaction is an arrangement between two related parties for the transfer of resources, services or obligations, irrespective of whether a price is charged or can affect the statement of profit or loss and the financial position of an entity.read more of the business:

  1. The transactions with the related parties are important as these transactions have more chances of inaccuracy because they are with the parties that are related to the owners/ directors of the company.
  2. The auditors should obtain the relevant evidence to check the nature, purpose, and extent of these transactions, and also, it should be evaluated that these transactions are at an arms-lengthTransactions Are At An Arms-lengthAn arm's length transaction is one in which two parties operate independently and the price agreed between them (also known as the transfer price) is free of any influence.read more price.

Importance

The substantive procedure is important to check the accuracy& completeness of a business transactionBusiness TransactionA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements.read more, measurement& valuation of an asset or liability of that business and to check that the disclosure of all material items is done properly, etc. These procedures are important while conducting the audit to comment upon the truth and fairness of the financial statements of the company. It provides assurance on the following assertions to the auditorAuditorAn auditor is a professional appointed by an enterprise for an independent analysis of their accounting records and financial statements. An auditor issues a report about the accuracy and reliability of financial statements based on the country's local operating laws.read more:

  1. The existence of asset and liability on the given date.
  2. The assets reported must be owned by the company on the given date.
  3. The liabilities reported must be the company’s obligations to pay on the given date.
  4. All the assets and liabilities that existed should be appropriately valued and recorded in the financial statements of the company.
  5. Events or transactions that are recorded must be related to that auditing period only.
  6. The transaction is recorded at the correct amount, and the only those expenses and revenues are recorded that pertain to that period.

Conclusion

Substantive audit procedures are the test designed for collecting the evidence about the business transaction so that the occurrences, validity, existence of the transaction can be verified, and the accuracy of their accounting treatment can be checked.

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