Audit Procedures: What They Are and How Auditors Test Financial Statements

What Are Audit Procedures?

Audit procedures are the specific methods auditors use to collect sufficient appropriate audit evidence about a company's financial statements. They are designed to address the audit risks identified during planning — the risk that material misstatements exist in the financial statements.

Under ISA 330 (Responses to Assessed Risks), auditors must design and perform procedures that respond to the assessed risks of material misstatement at the assertion level.

The Main Types of Audit Procedures

Inspection: Examining records, documents, or physical assets. For example, reviewing a sample of purchase invoices to verify that expenditure was properly authorised, or physically inspecting inventory to confirm it exists.

Observation: Watching a process being performed by someone else. For example, observing the client's year-end inventory count to assess whether it is conducted properly. Note that observation is limited — the process may be performed differently when the auditor is not present.

Enquiry: Seeking information from knowledgeable people inside or outside the entity. Enquiry alone is rarely sufficient — it must be corroborated by other procedures.

Confirmation: A specific type of enquiry — obtaining a direct response from a third party. For example, sending bank confirmation letters to verify account balances, or sending debtor circularisations to confirm receivable balances.

Recalculation: Checking the mathematical accuracy of documents or records. For example, re-adding a payroll listing or recalculating depreciation charges.

Re-performance: The auditor independently executing a procedure originally performed as part of the entity's internal controls. For example, re-performing an aged debt review.

Analytical procedures: Evaluating financial information through comparisons with expected values, prior periods, industry benchmarks, or budgets. Analytical procedures are required during planning and the final review stage and can also be used as substantive procedures.

Tests of Controls vs Substantive Procedures

Tests of controls: Designed to evaluate the operating effectiveness of internal controls. If controls are strong and operating effectively, the auditor can rely on them and reduce the extent of substantive testing.

Substantive procedures: Designed to detect material misstatements in financial statement assertions. Include tests of detail (examining individual transactions and balances) and substantive analytical procedures.

Financial Statement Assertions

Audit procedures are designed around financial statement assertions — the claims management makes when presenting the financial statements. Key assertions include: existence (assets exist), completeness (all transactions are recorded), accuracy (amounts are correct), valuation (assets and liabilities are valued appropriately), rights and obligations (the entity has rights to assets and owes recognised liabilities), and presentation and disclosure.

Directional Testing

Auditors use directional testing to efficiently address the risk of overstatement and understatement. Assets and income are generally tested for overstatement (existence/occurrence); liabilities and expenses are tested for understatement (completeness). This approach ensures procedures are focused on the most likely direction of misstatement.