The Substantive Procedure

Question 1

Substantive procedures

Answer 1

Substantive procedures are detailed tests that auditors perform to obtain evidence about the completeness, accuracy, and validity of data in financial statements. These procedures are crucial for identifying any material misstatements due to error or fraud.

1. What am I being asked to test?
   
   • Explanation: Determine the specific aspect you need to test, such as overstatement (existence of assets or transactions), understatement (completeness), or a particular aspect like valuation.
   • Example: If you are asked to test the existence of inventory, you would verify that the inventory recorded in the books actually exists.
2. How does the system operate and what documents exist?
   
   • Explanation: Understand the specific system and documents involved in the process described in the examination question.
   • Example: For a sales system, you might look at sales invoices, shipping documents, and customer orders to understand how sales are recorded.
3. What special tests are used for this area?
   
   • Explanation: Identify any specific audit tests relevant to the area, such as year-end inventory counts or direct confirmations of receivables.
   • Example: For receivables, you might send confirmation letters to customers to verify the amounts they owe.
4. What tests can I think of?
   
   • Explanation: Devise appropriate methods for gathering the evidence you need.
   • Example: In an IT system, you might use audit software to analyze transaction logs and identify any anomalies.

Let’s consider a practical example involving an external auditor:

Scenario: An external auditor is hired to audit the financial statements of ABC Corporation for the fiscal year 2024.

Steps the Auditor Might Take:

1. Planning the Audit:
   
   • Objective: Understand the business, its environment, and assess the risks of material misstatement.
   • Example: The auditor reviews ABC Corporation’s industry, regulatory environment, and internal controls.
2. Testing Internal Controls:
   
   • Objective: Evaluate the effectiveness of the company’s internal controls.
   • Example: The auditor tests the controls over cash handling to ensure that cash transactions are properly recorded and safeguarded.
3. Substantive Testing:
   
   • Objective: Verify the accuracy of account balances and transactions.
   • Example: The auditor confirms accounts receivable balances by sending confirmation requests to customers.
4. Reviewing Financial Statements:
   
   • Objective: Ensure the financial statements are prepared in accordance with accounting standards.
   • Example: The auditor checks that the financial statements comply with Generally Accepted Accounting Principles (GAAP).
5. Issuing an Audit Report:
   
   • Objective: Provide an opinion on the financial statements.
   • Example: The auditor issues an unqualified opinion, indicating that the financial statements present a true and fair view of ABC Corporation’s financial position.

By following these steps, the auditor helps ensure that ABC Corporation’s financial statements are reliable and provide a true representation of its financial performance and position¹².

I hope this clarifies the concept of substantive procedures in auditing. If you have any more questions or need further details, feel free to ask!

Embedded audit facilities (also known as resident audit software or integrated audit modules) are audit tools built into a client’s IT system, either temporarily or permanently. These facilities allow auditors to perform tests in real-time as transactions are processed.

1. Real-Time Testing:
   
   • Concept: Perform audit tests at the time transactions are being processed.
   • Example: An auditor uses embedded audit software to monitor and log all sales transactions in an e-commerce system as they occur, ensuring that each transaction is recorded accurately and completely.
2. Continuous Data Processing:
   
   • Concept: Useful for systems where data is continually processed and master files are constantly updated.
   • Example: In a banking system, embedded audit facilities can track and verify each transaction in real-time, ensuring that account balances are updated correctly.
3. Audit Trail Challenges:
   
   • Concept: Helpful in systems where it is difficult to provide a satisfactory audit trail.
   • Example: In an online retail system, embedded audit software can capture and store transaction details, providing a clear audit trail for each sale and return.

1. Compatibility and Cost:
   
   • Concept: Audit software must be compatible with the client’s IT system, which can be expensive.
   • Example: An audit firm incurs high setup costs when implementing audit software for a new client with a unique accounting system.
2. System Changes:
   
   • Concept: New audit software may be needed if the client changes its accounting system.
   • Example: A client upgrades its accounting software, requiring the audit firm to develop new compatible audit software.
3. Old Systems:
   
   • Concept: Difficulties in producing suitable audit software for old, purpose-written IT systems with incomplete documentation.
   • Example: An auditor struggles to create audit software for a legacy system with outdated and poorly documented code.
4. File Authenticity:
   
   • Concept: Risk of using non-genuine copies of client files for testing.
   • Example: An auditor insists on being present during the copying of client files to ensure they are genuine and current.

Auditing around the computer involves checking inputs to the system and comparing them with the outputs, without auditing the internal software.

1. Lack of Audit Evidence:
   
   • Concept: No audit evidence that programs are functioning properly if actual files or programs are not tested.
   • Example: An auditor cannot verify the accuracy of payroll calculations if they only check the input data (employee hours) and output data (paychecks) without examining the payroll software.
2. Discrepancy Investigation:
   
   • Concept: Difficulty in identifying the cause of discrepancies between input and output.
   • Example: An auditor finds a mismatch between sales orders and shipping records but cannot determine if the issue is due to a software error or data entry mistake.

Scenario: An auditor is auditing the financial statements of ABC Corporation, which uses an online sales system.

Steps and Concepts Applied:

1. Embedded Audit Facility:
   
   • The auditor uses embedded audit software to monitor all sales transactions in real-time, ensuring accurate recording.
2. Compatibility and Cost:
   
   • The audit firm incurs setup costs to implement the audit software compatible with ABC Corporation’s unique sales system.
3. System Changes:
   
   • ABC Corporation upgrades its sales system, requiring the audit firm to develop new audit software.
4. File Authenticity:
   
   • The auditor insists on being present during the copying of sales data files to ensure they are genuine.
5. Auditing Around the Computer:
   
   • The auditor checks sales orders (input) and compares them with shipping records (output) without auditing the internal sales software.

By following these steps, the auditor can effectively use embedded audit facilities and understand the risks and challenges of auditing around the computer.