Why This Matters
Substantive testing is where auditors move beyond understanding controls and actually dig into the numbers—this is how you verify that financial statements aren't materially misstated. You're being tested on understanding which procedure addresses which assertion (existence, completeness, accuracy, valuation, cut-off, rights and obligations, presentation and disclosure) and when to use each technique. These procedures form the backbone of audit evidence gathering, and exam questions frequently ask you to match the right test to the right risk.
The key insight here is that substantive procedures work in two directions: some test whether recorded items actually exist (overstatement risk), while others test whether real items made it into the records (understatement risk). Understanding this directional testing concept will help you tackle FRQ scenarios where you must design an appropriate audit response. Don't just memorize the procedure names—know what assertion each one primarily addresses and when it provides the strongest evidence.
Directional Testing: Existence vs. Completeness
These procedures test in opposite directions. Vouching moves backward from records to reality, while tracing moves forward from reality to records. Understanding this distinction is critical for matching procedures to the assertion being tested.
Vouching
- Tests the existence/occurrence assertion—starts with recorded transactions and traces back to supporting source documents
- Direction matters: moving from financial statements backward to invoices, contracts, and receipts catches fictitious or overstated transactions
- Best for overstatement risk when you suspect revenues are inflated or assets don't actually exist
Tracing
- Tests the completeness assertion—follows transactions from source documents forward into the financial statements
- Catches unrecorded transactions by starting with shipping documents, receiving reports, or other originating evidence
- Best for understatement risk when you suspect liabilities or expenses have been omitted
Compare: Vouching vs. Tracing—both examine the link between source documents and recorded transactions, but they test opposite assertions. Vouching catches overstatements (existence), tracing catches understatements (completeness). If an FRQ asks about revenue fraud, vouching is your answer; if it asks about unrecorded liabilities, think tracing.
External Evidence Procedures
External evidence from independent third parties is generally more reliable than internally generated documentation. The further removed the source is from management influence, the stronger the evidence.
Confirmation Procedures
- Provides direct third-party verification of account balances, transactions, or terms—considered highly reliable audit evidence
- Commonly applied to cash, receivables, and payables where external parties can independently verify amounts owed or held
- Positive vs. negative confirmations: positive requires a response regardless of agreement; negative only if the recipient disagrees (know when each is appropriate)
Observation of Physical Inventory
- Tests existence assertion through physical inspection—auditor witnesses the count to verify inventory actually exists in stated quantities
- Timing is critical: must occur at or near the balance sheet date, with roll-forward or roll-back procedures if counts occur at other times
- Also reveals condition issues such as obsolescence, damage, or slow-moving items affecting valuation
Compare: Confirmations vs. Physical Observation—both gather external/independent evidence, but confirmations work for intangible balances (receivables, bank accounts) while observation addresses tangible assets. Confirmations test existence and rights; observation primarily tests existence and condition.
Analytical and Computational Procedures
These procedures use relationships, expectations, and mathematical verification rather than examining individual documents. They're efficient for detecting material misstatements across large populations.
Analytical Procedures
- Evaluates financial information through plausible relationships—comparing current data to prior periods, budgets, industry benchmarks, or non-financial metrics
- Dual purpose: can serve as substantive evidence (when sufficiently precise) or as risk assessment during planning and final review phases
- Flags anomalies such as unusual fluctuations, unexpected trends, or ratios outside normal ranges that warrant investigation
Recalculation
- Verifies mathematical accuracy by independently re-performing calculations for depreciation, amortization, interest expense, tax provisions, and totals
- Tests the accuracy assertion directly—confirms that the math underlying reported figures is correct
- Often performed using CAATs (computer-assisted audit techniques) to efficiently test large volumes of calculations
Reconciliation Procedures
- Compares different sets of records to identify discrepancies—bank reconciliations, subledger-to-general-ledger tie-outs, intercompany eliminations
- Tests multiple assertions: accuracy, completeness, and existence depending on what's being reconciled
- Red flags include unexplained reconciling items, stale items, or adjustments lacking documentation
Compare: Analytical Procedures vs. Recalculation—analytics use relationships and expectations to identify where misstatements might exist, while recalculation verifies specific mathematical accuracy. Analytics are broad and efficient; recalculation is precise but narrow.
Tests of Details
These procedures examine individual transactions or account balances directly. They provide specific, item-level evidence but are more time-consuming than analytical procedures.
Tests of Details of Transactions
- Examines individual recorded transactions for validity, accuracy, and proper period recording
- Involves inspecting source documents—invoices, contracts, shipping records, purchase orders—to verify transaction attributes
- Addresses occurrence, accuracy, and cut-off assertions at the transaction level
Tests of Details of Balances
- Focuses on ending account balances rather than individual transactions throughout the period
- Includes confirming balances, examining supporting schedules, and testing valuation methods applied to year-end amounts
- Addresses existence, completeness, valuation, and rights/obligations for balance sheet accounts
Substantive Sampling
- Selects representative items from a population to test, then projects results to draw conclusions about the entire population
- Must be properly designed: sample size, selection method, and evaluation criteria affect whether conclusions are statistically valid
- Sampling risk exists—the risk that sample results don't reflect the true population characteristics (distinguish from non-sampling risk)
Compare: Tests of Transactions vs. Tests of Balances—transaction testing focuses on activity during the period (income statement and flow), while balance testing focuses on amounts at period end (balance sheet). Many audits use both, with the mix depending on assessed risk and control effectiveness.
Timing-Sensitive Procedures
These procedures specifically address the cut-off assertion and events affecting financial statement accuracy around period boundaries.
Cut-off Testing
- Verifies transactions are recorded in the correct accounting period—examines entries around year-end for proper timing
- Focuses on revenue and expense recognition where incentives exist to shift transactions between periods
- Procedures include reviewing sales and purchases just before and after period end, examining shipping and receiving logs, and testing credit memos
Subsequent Events Testing
- Reviews events occurring after the balance sheet date but before the audit report is issued for disclosure or adjustment requirements
- Type I events (adjusting) provide additional evidence about conditions existing at period end; Type II events (non-adjusting) require disclosure only
- Procedures include reading minutes, reviewing interim financials, and inquiring about litigation, commitments, or significant changes
Compare: Cut-off Testing vs. Subsequent Events Testing—both address timing, but cut-off ensures transactions hit the right period, while subsequent events ensures post-period developments are properly reflected. Cut-off affects recorded amounts; subsequent events may require disclosure or adjustment.
Inquiry and Corroboration Procedures
These procedures rely on information obtained from people rather than documents, but require support from other evidence. Inquiry alone is insufficient as audit evidence.
Inquiry and Corroboration
- Gathers information through questioning management, employees, legal counsel, and others with relevant knowledge
- Must be corroborated with other audit evidence—inquiry alone doesn't provide sufficient appropriate evidence for conclusions
- Useful for understanding processes, identifying risks, and assessing reasonableness of management's explanations and judgments
Management Representation Letters
- Written confirmation from management acknowledging responsibility for financial statements and completeness of information provided
- Required element of every audit—failure to obtain constitutes a scope limitation affecting the audit opinion
- Covers specific representations about fraud awareness, related parties, subsequent events, and completeness of disclosures
Compare: Inquiry vs. Management Representations—both involve obtaining information from management, but representations are formal, written, and required, while inquiries are ongoing throughout the engagement. Neither alone is sufficient; both require corroboration.
Specialized Transaction Testing
These procedures address specific high-risk areas requiring targeted audit attention.
- Examines transactions with related parties (subsidiaries, affiliates, key management, significant shareholders) for proper identification, disclosure, and valuation
- Tests arm's-length pricing to ensure transactions reflect fair market terms and aren't used to manipulate results
- High fraud risk area—related party transactions can obscure the true economic substance of arrangements
Quick Reference Table
|
| Existence/Occurrence | Vouching, Confirmations, Physical Observation |
| Completeness | Tracing, Analytical Procedures, Reconciliations |
| Accuracy | Recalculation, Reconciliation, Tests of Details |
| Valuation | Analytical Procedures, Tests of Balances, Recalculation |
| Cut-off | Cut-off Testing, Vouching/Tracing around period end |
| Rights and Obligations | Confirmations, Inspection of documents, Inquiry |
| Presentation and Disclosure | Analytical Procedures, Subsequent Events Testing, Related Party Testing |
| External Evidence Strength | Confirmations, Physical Observation, Third-party documents |
Self-Check Questions
-
If you suspect that sales revenue is overstated due to fictitious transactions, would you use vouching or tracing? What assertion does this test?
-
Compare and contrast positive and negative confirmations—when is each appropriate, and what factors influence the choice?
-
An FRQ describes a company with significant year-end pressure to meet earnings targets. Which two procedures would you prioritize to address revenue cut-off risk, and why?
-
How do analytical procedures differ when used during planning versus as substantive testing? What makes substantive analytics sufficient as audit evidence?
-
A client has material inventory and material accounts receivable. For each, identify the most appropriate substantive procedure and explain which assertion it primarily addresses.