CHAPTER 7

Introduction to Substantive Procedures

1. THE ROLE OF SUBSTANTIVE
PROCEDURES
1.1. The nature of substantive procedures
Substantive procedures are audit procedures performed to detect material misstatements in the figures and
presentation & disclosures reported in the financial statements.
1. Designed to generate evidence about the financial statement assertions.
2. Include;
a. Test of detail on transaction, account balances and disclosures, and
b. Analytical procedures
ISA 330 requires the auditors to carry out the following procedures:
1. Agree or reconcile the financial statements to the underlying accounting records.
2. Examine material journal entries.
3. Examine other adjustments made during the course of preparing the financial statements.
1. THE ROLE OF SUBSTANTIVE
PROCEDURES
1.2 Exam Technique: Devising Tests of Detail
1. What am I being asked to test?
a. Overstatement (occurrence of transactions or existence of assets or liabilities)
b. Understatement (completeness)
i. One particular aspect of an item.
2. How does the system operate and what documents exist?
3. What special tests are used for this area?
4. What tests can I think of?
 1. THE ROLE OF SUBSTANTIVE
PROCEDURES
1.3 Use of audit software
Audit software is computer programs used by the auditor to extract information from a computer-based
information system, for use in the audit.
The main types of audit software include:
a. interrogation programs, to access the client’s files and records and extract data for auditing
b. Interactive software, for use in interrogation of on-line IT systems
c. ‘resident code’ or ‘embedded’ software, to monitor and review transactions as they are being processed
by the client’s programs.
Examples;
a. Account analysis. Audit software may be used to interrogate the client’s data files for the general ledger,
and extract from the files all items above Rs.50,000 in the repairs expense account.
b. Calculating ratios and making comparisons. Audit software can be used to assist the auditor with
analytical procedures
1. THE ROLE OF SUBSTANTIVE
PROCEDURES
Embedded audit facilities
It is audit software that is built into the client’s IT system, either temporarily or
permanently.
The purpose of embedded audit facilities is to allow the audit to carry out tests at the time
that transactions are being processed, in ‘real time’.
This can be very useful for the audit of online systems where:
a. data is continually processed and master files are being continually updated, and/or
b. it is difficult, if not impossible, for the system to provide a satisfactory audit trail for
following transactions through the system.
c. An embedded audit facility may also print out details of the transactions it has
monitored, or copy them to a computer file, so that the auditor can study the transactions.
1. THE ROLE OF SUBSTANTIVE
PROCEDURES
Problems with using audit software
1. When it is being used for the first time for a client, so that the audit firm has set-up costs.
2. The client entity changes its accounting system, so that new audit software is needed.
3. There may be problems with producing suitable audit software when the client has an
old
purpose-written IT accounting system for which there is incomplete system
documentation.
4. The auditor should also be aware of the possibility that if he uses copies of the client’s
files for carrying out tests with audit software that the client may provide a file that is not
actually a copy of the current ‘live’ files.
1. THE ROLE OF SUBSTANTIVE
PROCEDURES
• 1.4 Auditing around the computer
1. The auditor looks at input to the system, and compares the actual output with
the output that should be expected.
2. Greater audit risk than auditing of the client’s internal software, because:
a. If the actual files or programs are not tested, there will be no audit evidence that the
programs are functioning properly, as documented
b. Where the auditor finds discrepancies between the input to the system and the
output from the system, there is no way of finding out how the discrepancy has
occurred.
I. Increases the risk that the auditor will be unable to write an unqualified audit report.
1. THE ROLE OF SUBSTANTIVE
PROCEDURES
• 1.5 Methods of obtaining audit evidence
• Inspection
• Observation
• Inquiry
• Confirmation
• Re-calculation
• Re-performance
• Analytical procedure
1. THE ROLE OF SUBSTANTIVE
PROCEDURES
1.6 Directional Testing
• Two main types of misstatements;
• Errors which may result in either under or overstatement of figures.
• Omission, which result in understatement
• Underinvestment is much more difficult to detect than overinvestment.
• Understatement - to audit something that isn’t there;
• Completeness
• Overstatement – checking what is there is valid
• Existence or occurrence
• Process – auditing the trial balance of client entity balances
• Debit balance in general ledger = credit balance
1. THE ROLE OF SUBSTANTIVE
PROCEDURES
• Conclusions:
• An overstatement of a debit entry – must be a corresponding understatement of another debit
entry or an overstatement of a credit entry.
• Understatement of a credit balance for one item – either an overstatement of an other credit
balance or an understatement of a debit balance
• Allows the auditor to work in a cost-effective and efficient way;
• The audit tests debit items (assets and expenses) for overstatement only.
• He tests credit items (liabilities, income and equity) for understatement only.

• Correct starting point for the test;

• Tests to detect overstatement – the starting point should be the figures in the accounting records.
• Tests to detect understatement – the starting point should be a source outside the accounting
records.
1. THE ROLE OF SUBSTANTIVE
PROCEDURES
1.7 The significance of the audit of statement of financial position items
• The auditor will usually pay more attention to the statement of financial position than
to the income statement/statement of comprehensive income.
• Reason -if the current statement of financial position is ‘correct’ and if the previous statement
of financial position was correct, then the profit figure linking the two statements of financial
position must also be correct.
• If assets and liabilities are correctly stated, equity (assets minus liabilities) will also be
correctly stated.
• The emphasis of the audit will be focused as follows:
• Assets – existence, rights and obligations and accuracy valuation and allocation.
• Liabilities – completeness, cut-off and accuracy.
2. ANALYTICAL PROCEDURES: ISA 520
2.1 Using analytical procedures
• At the planning stage, in order to:
• gain a better understanding of the client entity and its business, and
• help identify areas of high audit risk
• At the end of the audit, in the overall review of the audit, to assist the auditor when
forming an overall conclusion as to whether the financial statements are consistent with his
understanding of the entity.
• Analytical results may also be used:
• As a substantive procedures during the audit, in the audit work on the income statement and
statement of financial position.
2. ANALYTICAL PROCEDURES: ISA 520
2.2 The nature of the analytical procedures (ISA 520)
• “Evaluations of financial information through analysis of plausible relationships among
both financial and non-financial data”
• Evaluate:
• Expected ratios
• Ratios from pervious financial periods.

• If key ratios are close to what they are expected to be, will be considered as ‘reliable’ and
‘accurate’ evidence.
• If a ratio is very different from what is expected, the auditor should investigate the reason
for the variation.
• Might be misstatement in the financial statements
2. ANALYTICAL PROCEDURES: ISA 520
• Essential feature is ‘comparison’ – key relationship between figures.
• Comparison with prior accounting periods, expected results, industry average results and
comparable parts of the same entity.

• Limitations;
• Its usefulness depends on the quality of the underlying financial information.
• For comparison purposes, the information must be calculated on a consistent basis.
• The two figures used to calculate a ratio must be logically related.
• The auditor needs to understand the client’s business, so that he is able to understand the
potential significance of ratios, or reasons for differences.
2. ANALYTICAL PROCEDURES: ISA 520
2.3 Analytical procedures in substantive testing
• Determine the suitability of particular substantive analytical procedures for given assertions (material
misstatement)
• Develop an expectation of recorded amounts or ratios and evaluate whether that expectation is sufficiently
precise to identify a misstatement.
• The accuracy with which the amounts can be predicted,
• The extent to which information can be disaggregated,
• The availability of information

• Evaluate the reliability of the data from which the expectation has been developed,
• The source of the information;
• comparability of the information available;
• the nature and relevance of the information available (not be suitable if they are goals rather than
expectations); and
• controls over the preparation of the data.
• determine what level of difference from expected amounts is acceptable without further investigation
2. ANALYTICAL PROCEDURES: ISA 520
• The auditor will normally use analytical procedures to obtain supplementary audit
evidence.
• Substantive analytical procedures may provide sufficient appropriate audit
evidence for a particular assertion if:
• the assessed risk of material misstatement is not considered significant; and
• the outcome is sufficiently accurately predictable such that sufficient appropriate audit
evidence could be obtained through the use of substantive analytical procedures alone.
2. ANALYTICAL PROCEDURES: ISA 520
2.4 Investigation of fluctuations and relationships
• If the audit finds:
• fluctuations or relationships which are inconsistent with other information,
• unacceptable levels of differences from expected amounts

• Then ISA 520 requires him to:

• make enquiries of management and verify management’s responses, and
• perform other audit procedures as necessary

• These enquiries, following analytical procedures, will involve:

• Using other audit evidence to help explain the ratios obtained from analytical procedures,
and their unexpected and unusual value
• Asking management for explanations of the unusual/unexpected ratios.
• Should be confirmed by further audit work.
2. ANALYTICAL PROCEDURES: ISA 520
2.5 Common Ratios
• Profitability ratios:
• ROCE, Profit/ sales ratio (Net profit margin or a gross profit ratio), asset turnover ratio
• Working capital efficiency ratios:
• Average days to collect receivables, inventory turnover, average time to pay
• Liquidity ratios:
• Current ratio, Quick ratio
• Debt ratios:
• Gearing, interest coverage ratio
• Investor ratios:
• Earning per share, price to earning ratio, dividend yield, dividend cover, dividend payout ratio