Tests of controls - Distinguishing tests of controls and sub...

Learning Outcomes

After reading this article, you will be able to distinguish clearly between tests of controls and substantive procedures in audit. You will understand their distinct purposes, be able to provide examples for each, and explain their role in the audit process. You will also develop the ability to identify exam questions asking for each type of procedure and avoid common errors in this area.

ACCA Foundations in Audit (FAU) Syllabus

For ACCA Foundations in Audit (FAU), you are required to understand when and why an auditor applies tests of controls and substantive procedures. Revision should focus on the following points:

• The difference between tests of controls and substantive procedures
• The main objectives and outcomes of tests of controls versus substantive procedures
• When to apply each type of procedure during an audit
• Examples of audit activities that are tests of controls and those that are substantive procedures
• The role of each type of procedure in obtaining audit evidence
• The risk of misclassification and its impact on exam marks

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the primary purpose of a test of control?
   1. To detect all errors in balances
   2. To evaluate the effectiveness of client controls
   3. To recalculate closing balances
   4. To verify compliance with tax laws
2. Which of the following is a substantive procedure?
   1. Inspecting invoices for evidence of authorisation
   2. Recalculating the depreciation charge for the period
   3. Observing staff performing a control procedure
   4. Reviewing control account reconciliations for evidence of performance

3. True or false? Substantive procedures can be omitted if the auditor finds controls are working well.

4. Provide one example of a test of control and one example of a substantive procedure in the purchases cycle.

Introduction

Audit procedures fall into two major types: tests of controls and substantive procedures. Both play key roles in the audit process but have different aims and are used at different audit stages. Confusing the two can lead to errors in providing evidence and to lost marks in the ACCA exam. It is essential to be able to define, differentiate, and provide tailored examples for each.

TESTS OF CONTROLS AND SUBSTANTIVE PROCEDURES: THE BASICS

Audit evidence is gathered throughout the engagement. To do this effectively, auditors use different types of procedures depending on the objectives at each stage.

Key Term: test of control
An audit procedure designed to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level.

Key Term: substantive procedure
An audit procedure designed to detect material misstatements at the assertion level. Substantive procedures include tests of details and substantive analytical procedures.

PURPOSE AND APPLICATION

Tests of controls aim to determine whether client's controls (such as authorisations, reconciliations, reviews, or automated checks) are working as intended throughout the period. These tests provide evidence on the reliability of the system and inform the auditor whether it is appropriate to reduce substantive testing in areas where controls operate effectively.

Substantive procedures are carried out to obtain direct evidence about the amounts and disclosures in the financial statements. Substantive procedures are always required—even where controls are strong—although their extent may vary depending on the results of control testing.

Key Term: control
Policies or procedures designed to provide reasonable assurance that the entity's objectives will be achieved regarding reliable financial reporting, effectiveness and efficiency of operations, and compliance with regulations.

KEY DIFFERENCES

Worked Example 1.1

You are auditing the payroll system. Describe a suitable test of control and a substantive procedure.

Answer:
Test of control: Inspect a sample of payroll payment authorisation forms for evidence of manager approval.

Substantive procedure: Recalculate gross and net pay for selected employees from personnel records and timesheets, and agree amounts to the payroll summary.

PRACTICAL APPLICATION AND EXAM STRATEGY

Auditors frequently perform both types of procedure in specific audit areas.

• Tests of controls are applied by:

  • Inspecting purchase invoices for authorisation signatures
  • Observing whether inventory counts follow company instructions
  • Reperforming the reconciliation carried out by the finance department

• Substantive procedures are applied by:

  • Sending confirmation letters to customers to verify receivables balances
  • Comparing recorded sales to supporting invoice documents
  • Performing analytical review of gross profit margins

Worked Example 1.2

During the audit of sales, you observe that not all sales invoices have a supervisor’s signature. What should you do next: perform more tests of control or substantive procedures?

Answer:
The lack of supervisor signatures indicates possible control failure. The auditor should increase the extent of substantive procedures (such as vouching invoices to delivery notes and customer orders) to obtain adequate evidence on completeness and accuracy of sales.

Exam Warning

A common error is to assume that strong controls eliminate the need for substantive procedures. In the ACCA exam, you must state that substantive procedures are always required, even when controls are assessed as effective.

SUMMARY TABLE: TESTS OF CONTROLS VS SUBSTANTIVE PROCEDURES

Key Point Checklist

This article has covered the following key knowledge points:

• Define tests of controls and substantive procedures
• Explain the objectives and timing of each type of procedure
• Identify examples relevant to key transaction cycles
• Recognise that substantive procedures cannot be omitted, even with strong controls
• Distinguish between testing controls and examining balances during an audit

Key Terms and Concepts

• test of control
• substantive procedure
• control