Substantive Testing: Cash, Receivables,

Inventory and Fixed Assets

To form the basis of an opinion on the fairness of the financial statements, the third
generally accepted fieldwork standard requires the gathering of sufficient competent
evidential matter. Substantive tests are the procedures by which auditors gather this
evidential matter.

Although the nature, extent, and timing of substantive tests is a matter of professional
judgment, effective client internal control is a positive influence. Accordingly, the auditor
may decide to decrease the amount of substantive testing, omit certain procedures, and/or
schedule interim testing.

Conversely, weak internal control will likely result in increased substantive testing, the
need for additional audit procedures, and/or scheduling testing at or after year-end.

What Is Involved In Substantive Testing?

Well, in general, substantive tests include:

 Tests of transactions
 Tests of details of account balances
 Analytical procedures

In testing transactions, the auditor is concerned with tests of:

 Omitted transactions and account understatement (tracing source documents to the

books of entry)
 Invalid or unsupported transactions and account overstatement (tracing recorded
transactions to source documents).

In analyzing details of account balances, auditors use professional judgment in

determining which accounts to scrutinize. Some of the accounts commonly requiring
‘scrutiny’ are:

 Repairs and maintenance

 Fixed assets
 Officers’ salaries
 Contributions
 Travel and entertainment
 Income tax provisions
Analytical procedures include the study and comparison of the relationships between
data. This involves the comparison of current period financial information with:

 Prior period information

 Expected results
 Predictable pattern information
 Intra-industry information
 Nonfinancial information

Next are examples of substantive testing procedure for cash, receivables, inventory and
fixed assets balances. Read on…

Substantive Tests of Cash Balances

A. Presentation and Disclosure

[1]. Read or review the financial statements to verify proper classification.

[2]. Read or review the financial statements to verify disclosures such as those relating to
compensation balances.

[3]. Determine the conformity with GAAP.

B. Valuation or Allocation

[1]. Simultaneously count cash on hand and negotiable securities.

[2]. Confirm directly with the bank:

 Account balances
 Direct liabilities to bank
 Contingent liabilities to bank
 Letters of credit
 Security agreements under the Uniform Commercial Code
 Authorized signatures

[3]. Count petty cash fund and reconcile with vouchers.

C. Completeness

[1]. Obtain bank cut-off statement and determine propriety of year-end outstanding checks
and deposits-in-transit.

[2]. Examine or prepare year-end bank reconciliation.

[3]. Prepare a proof of cash.

[4]. Perform analytical procedures.

D. Existence or Occurrence (See Valuation or Allocation)

E. Rights and Obligations

[1]. Read minutes of the board of directors’ meetings.

[2]. Determine existence of compensating balances, levies, etc.

[3]. Verify names on accounts through confirmation requests.

F. Related Income Statement Effects

Substantive Tests of Receivable Balances

A. Presentation and Disclosure

[1]. Determine appropriate classification of account balances.

[2]. Read or review the financial statements in order to verify disclosure of:

 Restrictions—pledging, factoring and discounting

 Related party transactions

[3]. Trace amounts on trial balance to general ledger control accounts and subsidiary ledger
totals.
B. Valuation or Allocation

[1]. Confirm account balances where reasonable and practicable using positive and/or
negative confirmation requests.

[2]. Examine collections in the subsequent period cash receipts journal.

[3]. Examine and verify amortization tables.

[4]. Examine aging schedules.

[5]. Review adequacy of allowance for doubtful accounts.

[6]. Review collectability by checking credit ratings (e.g., Dun and Bradstreet ratings).

[7]. Verify clerical accuracy and pricing of sales invoices.

[8]. Foot daily sales summaries and trace to journals.

[9]. Perform tests for omitted and invalid (or unsupported) transactions with respect to
subsidiary ledger account balances.

C. Completeness

[1]. Perform sales and sales return cut-off tests.

[2]. Perform analytical procedures.

[3]. Test for omitted transactions.

D. Existence or Occurrence

[1]. Inspect note agreements.

[2]. Confirm accounts receivable and notes receivable balances.

[3]. Review client documentation.

E. Rights and Obligations

[1]. Read minutes of board of directors’ meetings.

[2]. Read leases for pledging agreements.

[3]. Determine pledging and contingent liabilities to bank by using a standard bank
confirmation.

F. Related Income Statement Effects

[1]. Review instalment sales profit recognition.

[2]. Verify accuracy of sales discounts and term discounts.

[3]. Review bad debt expense computations.

[4]. Recalculate interest income on notes receivable.

Substantive Tests of Inventory

A. Presentation and Disclosure

[1]. Read or review the financial statements to verify footnote disclosure of:

 Valuation method and inventory flow, e.g., lower-of-cost-or-market value, first-in-

first out
 Pledged inventory
 Inventory in or out on consignment
 Existence of and terms of major purchase commitments

B. Valuation or Allocation

[1]. Verify the correct application of lower-of-cost-or-market value.

[2]. Recalculate inventory valuation under the full absorption costing method.

[3]. Verify the quality of inventory items.

[4]. Vouch and test inventory pricing.

[5]. Perform analytical procedures.

[6]. Verify the propriety of inventory flow.

[7]. Consider using the services of a specialist to corroborate the valuation of inventory (e.g.,
a gemmologist to corroborate the valuation of precious stones).
C. Completeness

[1]. Perform cut-off tests for purchases, sales, purchase returns, and sales returns.

[2]. With respect to tagged inventory, perform tests for omitted transactions and tests for
invalid transactions.

[3]. Verify the clerical and mathematical accuracy of inventory listings.

[4]. Reconcile physical inventory amounts with perpetual records.

[5]. Reconcile physical counts with general ledger control totals.

D. Existence or Occurrence

[1]. Observe client inventory counts.

[2]. Confirm inventory held in public warehouses.

[3]. Confirm existence of inventory held by others on consignment.

E. Rights and Obligations

[1]. Determine existence of collateral agreements.

[2]. Read consignment agreements.

[3]. Review major purchase commitment agreements.

[4]. Examine invoices for evidence of ownership.

[5]. Review minutes of the board of directors’ meetings.

F. Related Income Statement Effects

[1]. Verify that ending inventory on the balance sheet is identical to ending inventory in the
Cost of Goods Sold section.

Substantive Tests for Fixed Assets

A. Presentation and Disclosure

[1]. Read the financial statements in order to verify:

 Disclosure of historical cost

 Disclosure of depreciation methods under GAAP
 Financial statement classification
 Disclosure of restrictions

B. Valuation or Allocation

[1]. Examine invoices.

[2]. Inspect lease agreements and ascertain the proper accounting treatment (e.g., capital vs.
operating lease).

[3]. Analyse repairs and maintenance accounts.

[4]. Analyse related accumulated depreciation accounts.

[5]. Vouch entries in fixed asset accounts.

[6]. Test extensions and footings on client-submitted schedules.

C. Completeness

[1]. Perform analytical procedures.

[2]. Inspect fixed assets.

[3]. Examine subsidiary schedules.

[4]. Reconcile subsidiary schedules with general ledger control.

D. Existence or Occurrence

[1]. Inspect fixed assets.

[2]. Examine supporting documentation.

E. Rights and Obligations

[1]. Inspect invoices.

[2]. Inspect lease agreements.

[3]. Inspect insurance policies.

[4]. Inspect title documents.

[5]. Inspect personal property tax returns.

[6]. Read minutes of the board of directors’ meetings.

F. Related Income Statement Effects

[1]. Recalculate depreciation expenses.

[2]. Recalculate gain or loss on disposal of fixed assets.

Substantive Auditing Tests

Substantive tests performed by the auditor consist of tests of details of transactions and
account balances, and analytical procedures. The objective of substantive tests is to
detect material misstatements in the financial statements. The auditor selects particular
substantive tests to achieve audit objectives and considers, among other things, the risk
of material misstatement of the financial statements, including the assessed levels of
control risk, and the expected effectiveness and efficiency of such tests [US Statement on
Auditing Standard No. 31, “Evidential Matter” 1980]. The evidential matter provided
by the combination of the auditor’s assessment of inherent risk and control risk and by
substantive tests provides a reasonable basis for the resulting opinion on the fairness of
the financial statements.

Audit Evidence

The auditor’s responsibility is to design audit procedures that will provide reasonable
assurance that any material misstatements due to errors or irregularities will be
detected and removed from the financial statements. Errors are unintentional mistakes
including clerical mistakes, mistakes in the application of accounting principles, and
misinterpretation of facts. Irregularities result from intentional distortions such as fraud or
defalcations. It is important to note that an audit does not include procedures specifically
designed to detect illegal acts [Statement on Auditing Standard No. 54, “Illegal Acts by
Clients” 1988].

The auditor must collect evidence and document the collection process. Evidence
requirements are found in the Third Standard of Fieldwork, which states:

sufficient competent evidential matter is to be obtained through inspection, observation,

inquiries, and confirmations to afford a reasonable basis for an opinion regarding the
financial statements under audit.

More specifically, the evidence is obtained to support or refute the assertions that pertain to
the accounts in the financial statements. Financial statement assertions can be classified as
follows: existence or occurrence, completeness, rights and obligations, valuation and
allocation, and presentation and disclosure.

For evidence to be useful to the auditor it must possess to some degree each of four
characteristics: relevance, freedom from bias, objectivity, and persuasiveness. Six types of
audit evidence are available to the auditor to support a given audit objective: physical
evidence, representations by third parties, mathematical evidence, documentation,
representations by client personnel, and data interrelationships.

Test Objectives

The overall test objective relates either to tests of controls or substantive tests. Tests of
controls determine the effectiveness of the design and operation of control structure
policies and procedures. The results of these tests assist in determining the nature, timing,
and extent of substantive tests. Substantive tests determine if material dollar or disclosure
misstatements exist in the financial statements. If the client has established a good internal
control structure, the auditor may decide to restrict substantive testing because the client’s
internal control structure is likely to prevent or detect material misstatements. This
relationship means that if the financial statements are less likely to contain material
misstatements, the auditor may properly do less substantive audit work than if the financial
statements are likely to contain material misstatements.

Types of Substantive Tests

Substantive tests can be classified as follows:

 analytical tests;
 observation and inquiry;
 tests of transactions; and
 tests of balances.
Analytical tests are evaluations of financial information and nonfinancial data, and may
be used as substantive tests. In fact, some audit objectives may be difficult or impossible to
achieve without relying to some extent on analytical tests because they may be more effective
or efficient than tests of details. For example, analytical tests may be more effective than tests
of details in testing the completeness assertion for income statement accounts.

Although not used extensively, inquiry can be used as a substantive test. For example,
inquiries regarding subsequent events would be a substantive test because they provide
evidence regarding the adequacy of disclosures in the financial statements. Tests of
transactions are the auditor’s examination of the documents and accounting records involved
in the processing of a specific type of transaction. A substantive objective is accomplished
when the purpose of the auditor’s examination is to determine if dollar errors have occurred
during the processing of the transaction. Tests of balances are audit tests performed directly
on a balance to identify misstatements in an account. Two specific examples of tests of
balances are confirmation and observation.

Specific Audit Techniques

The major types of tests can be classified into specific methods to gather evidence as
follows:

 Physical Examination – Physical examination is the activity of gathering physical

evidence. As a substantive test, it involves the examination of assets that have a
tangible existence, such as cash or equipment. Physical examination is an activity
used in the observation of inventories. This activity is a generally accepted auditing
procedure used as a substantive test. The independent auditor who issues an opinion
when he or she has not employed this procedure has the burden of justifying the
opinion expressed [Statement on Auditing Standard 1, 1982, “Inventories”]. The
primary audit assertion tested by physical examination is existence. However, it also
provides evidence about valuation. The completeness assertion may also be tested
through physical examination in that items omitted from the financial statements may
be discovered.
 Confirmation – The confirmation technique requires the auditor to request a written
response from a specific third party about a particular item affecting the financial
statements. The primary assertions tested by confirmation are existence and rights and
obligations. This technique can also provide evidence about the valuation or
allocation, completeness, and presentation and disclosure assertions. The auditor’s
decision to use confirmation procedures rather than, or in conjunction with, tests
directed toward documents or parties within the entity is based upon a desire to use
substantive tests to obtain more or different evidence about a financial statement
assertion. For example, confirmation of accounts receivable is a generally accepted
auditing procedure that will be performed unless certain conditions are met
[Statement on Auditing Standards No. 67, 1991, “The Confirmation Process”].
 Vouching – Vouching is the examination of documents that support a recorded
transaction or amount. Because the purpose of the vouching technique is to obtain
evidence about a recorded item in the accounting records, the direction of the search
for the supporting documents is crucial. The direction of testing is from the recorded
item to supporting documentation. Vouching can best provide evidence addressing
 existence or occurrence, valuation or allocation, rights and obligations, and
presentation and disclosure.
 Tracing – Tracing is the following of source documents to their recording in the
accounting records. This procedure is performed by selecting source documents and
tracing them through the accounting system to their ultimate recording in the
accounting records. Tracing is often used as a test of the completeness assertion.
 Re-performance – The re-performance of client activities involved in the accounting
process is a common substantive technique. Evidence is obtained about client
activities by repeating the activities and comparing the result with the client’s result.
 Reconciliation – Reconciliation is the process of matching two independent sets of
records. In an audit, one set of records is usually the client’s and the other set is the
third party’s. Reconciliation primarily serves the assertions of completeness and
existence or occurrence. The preparation of a bank reconciliation is a common
example of this technique.
 Inquiry – Inquiry is a broad audit technique that entails asking questions. Inquiry is
used extensively in an audit and as a substantive test it may address any of the
assertions.
 Inspection – Inspection is the examination of documents in other than the vouching
or tracing techniques. It is the critical reading of a document comparing the
information therein with other information known to the auditor or recorded in the
accounts. Because of the variety of documents that auditors may inspect, the
inspection technique addresses all the financial statement assertions.
 Analytical Procedures – Analytical procedures encompass a number of specific
procedures the auditor may perform. Auditors employ specific procedures to assess
the reasonableness of data and to identify unusual relationships. Because unusual
relationships among data can occur for a number of reasons, analytical procedures
may address all five financial statement assertions.

Audit Risk

The auditor’s responsibility is to reduce the possibility of audit risk to an acceptably low
level. The auditor uses the assessed levels of control risk and inherent risk to determine
the acceptable level of detection risk for financial statement assertions. The auditor then
uses the acceptable level of detection risk to determine the nature, timing, and extent of
substantive procedures to be used to detect material misstatements in the financial statement
assertions. It is not appropriate, however, for an auditor to rely completely on the assessments
of inherent risk and control risk to the exclusion of performing substantive tests of account
balances and classes of transactions where misstatements could exist that might be material
when aggregated with misstatements in other balances or classes [US Statement on
Auditing Standards No. 47, 1983, “Audit Risk and Materiality in Conducting an
Audit”].

As the acceptable level of detection risk decreases, the assurance provided from substantive
tests should increase. Consequently, the auditor may do one or more of the following
[Statement on Auditing Standard No. 55, 1988, ”Consideration of the Internal Control
Structure in a Financial Statement Audit”]:
[1]. change the nature of substantive tests from a less effective to a more effective procedure,
such as using tests directly toward independent parties outside the entity rather than tests
directed toward parties or documentation within the entity;

[2]. change the timing of substantive tests, such as performing them at year-end rather than at
an interim date;

[3]. change the extent of substantive tests, such as using a larger sample size.

In considering efficiency, the auditor recognizes that additional evidential matter that
supports a further reduction in the assessed level of control risk for an assertion would
result in less audit effort for the substantive tests of that assertion. The auditor weighs the
increase in audit effort associated with the additional test of controls that is necessary to
obtain such evidential matter against the resulting decrease in audit effort associated with the
reduced substantive tests. When the auditor concludes it is inefficient to obtain additional
evidential matter for specific assertions, the auditor uses the assessed level of control risk
based on the understanding of the internal control structure in planning the substantive tests
for those assertions.

Although the inverse relationship between control risk and detection risk may permit the
auditor to change the nature or the timing of substantive tests or limit their extent, ordinarily
the assessed level of control risk cannot be sufficiently low to eliminate the need to perform
any substantive tests to restrict detection risk for all of the assertions relevant to significant
account balances or transaction classes. Consequently, regardless of the assessed level of
control risk, the auditor should perform substantive tests for significant account balances and
transaction classes.

An auditor must determine when to perform each audit procedure [Statement on

Auditing Standards No. 47, 1983, “Audit Risk and Materiality in conducting an
Audit”]. Audit procedures performed before year-end are known as interim procedures. In
deciding whether to perform interim procedures, the auditor should consider the entity’s
internal control structure, changing business conditions, the risk associated with the various
account balances, and the predictability of account balances at year-end. If interim
substantive tests are performed, additional tests must be performed at year-end. Then year-
end tests may involve further tests of details or analytical procedures.