Definition
Substantive procedure is a term widely used in finance and audit. It refers to the specific tests and methods auditors use to obtain evidence determining the accuracy, completeness, and validity of an entity’s financial records or statements. This can include confirming balances with third parties, examining documents, physically verifying an asset, and more.
Key Takeaways
- Substantive Procedures are essential auditing techniques that investigate an entity’s financial status and operations. They are employed to gather evidential matter that supports the financial information presented by the company, ensuring the data’s accuracy, completeness and validity.
- These procedures are not restricted to the evaluation of financial statements but also extend to investigate detailed transactions and balances, monitor internal controls over financial reporting, cross-checking financial information with relevant documentation, and checking the accuracy of account balances.
- The primary use of Substantive Procedures is to identify material misstatements or frauds in the financial statements, which would significantly affect the decision-making process of investors, shareholders and other users of financial information. These are crucial in an audit to guarantee financial statements are free from material misstatements, either due to fraud or error.
Importance
Substantive procedure is a crucial term in the world of finance and accounting as it refers to the methods or steps that auditors use to gather evidence, ensuring the financial information or statements of a company are accurate and in adherence to the relevant accounting standards and regulations.
It is important because it plays a pivotal role in detecting any material misstatement at the assertion level, whether due to error or fraud.
Substantive procedures serve to validate the overall integrity of the financial reports, fostering trust and reliability for stakeholders making investment or other financial decisions.
Therefore, the effectiveness of substantive procedures directly contributes to the credibility and transparency of a company’s financial reporting.
Explanation
Substantive procedures serve a crucial purpose in financial auditing by testing the veracity and reliability of financial transactions, balances, and disclosures. The chief goal is to detect material misstatements in the financial statements, which could be a consequence of fraud or error.
These procedures help auditors to gather relevant evidence to address any potential risk of misstatements. By scrutinizing transactions and balances closely, auditors can reassure stakeholders that the financial statements present a true and fair picture of a company’s financial state.
Substantive procedures can be broadly classified into two categories: tests of details and substantive analytical procedures. Tests of details delve into individual transactions or balances to validate their accuracy, while substantive analytical procedures examine financial data and plausible relationships among both financial and non-financial data.
Utilized effectively, substantive procedures provide a robust check on the integrity of a company’s financial records, a pivotal element in ensuring transparency and trustworthiness in business operations.
Examples of Substantive Procedure
Substantive procedures, in the field of financial auditing, are detailed tests performed to detect material misstatements in the financial statements’ numbers and footnote disclosures. A substantive test may focus on the overall reasonableness of figures reported, or follow a detailed examination of transactions leading to reported figures. Here are three real-world examples of how substantive procedures can be used:
Checking the Accuracy of Sales Records: An auditor may apply substantive procedures to verify if a company’s reported sales revenue truly reflects its transaction records. This might involve taking a random sample of sales transactions (including invoices and cash receipts), and then tracing each one back to the initial sales order to confirm accuracy.
Validation of Inventory Figures: A second example may involve physical inventory counts. The auditor might go to the company’s warehouse, randomly select several items, check the actual count against the inventory records, and verify the costing methods and calculations used. This is done to ensure that the inventory figures reported in the financial statements are complete, valid and accurate.
Verification of Property and Equipment: A company might state they own certain properties or equipment. A substantive procedure could involve inspecting the physical assets to verify their existence and condition, reviewing title deeds or lease agreements to confirm ownership or rights to use, checking depreciation methods and calculations against those policy disclosed and comparing the carrying amount to its recoverable amount to identify impairment if any.
FAQ for Substantive Procedure
What is a Substantive Procedure?
Substantive procedures are tests carried out to obtain evidence as to the completeness, accuracy, and validity of the data upon which financial statements are based. They are essentially detailed tests that detect material misstatements or frauds in the financial information of an organization.
Why are Substantive Procedures important?
Substantive procedures are essential in providing auditors with verifiable evidence regarding financial information. This evidence is crucial in drawing conclusions and giving an opinion about the fairness and reliability of a company’s financial statements.
What is the difference between Test of Details and Substantive Procedures?
Tests of details usually refer to the substantive procedures that relate to transaction-level assertions and account balance assertions. Substantive procedures, on the other hand, is an umbrella term that includes tests of details as well as substantive analytical procedures.
How are Substantive Procedures performed?
Substantive procedures are performed through methods such as inspection, observation, confirmation, recalculation, reperformance, analytical procedures, and inquiry. The exact method chosen largely depends on the nature of the account and the auditor’s assessment of the risk of material misstatement.
What are the types of Substantive Procedures?
There are generally two types of substantive procedures: substantive tests of transactions (also known as transaction-level substantive tests) and substantive tests of balances. Transaction-level tests check the details within the transactions that make up the account balance. Balance-level tests examine the overall reasonableness of the account balances.
Related Entrepreneurship Terms
- Audit Evidence
- Testing Detail
- Material Misstatement
- Financial Statements Verification
- Internal Control Evaluation
Sources for More Information
- Investopedia – A comprehensive resource for investing education, personal finance, market analysis and free trading simulators.
- AccountingTools – A site providing information on accounting, audit, financial analysis, and corporate finance.
- ACCA Global – The official website of the Association of Chartered Certified Accountants, a global professional body issuing highly respected and valued international qualifications in business.
- AICPA – American Institute of CPAs, the world’s largest member association representing the accounting profession.
