Substantive-risk

Substantive risk refers to the potential for material misstatement in financial statements, arising either from the inherent nature of the activity itself or from weaknesses in the entity's internal controls. It represents the auditor's assessment of the likelihood that errors or fraud could occur and go undetected, either individually or in aggregate. This assessment considers both the susceptibility of accounts and disclosures to misstatement and the effectiveness of the entity's controls in preventing or detecting such misstatements. Auditors use this assessment to design appropriate audit procedures. Substantive risk is a key component of the audit risk model. It informs the level of testing needed to reduce audit risk to an acceptable level, and influences the nature, timing and extent of audit procedures.

Substantive-risk meaning with examples

• In assessing the substantive risk for revenue recognition at a technology company, the auditor considered factors such as the complexity of software licensing agreements, the company's history of aggressive revenue practices, and the potential for fraudulent revenue inflation. Due to the complexity, the auditor would likely assess the risk as high. This informed the testing procedures, e.g., the auditor may need to verify source documents and agreements extensively to ensure completeness, accuracy and validity.
• When auditing a manufacturing firm with inventory, the auditor considered the substantive risk related to valuation. Factors influencing the assessment included obsolescence, and the potential for damage. If the company's controls over inventory counts and valuations were weak, the substantive risk was higher. The auditor may perform extensive physical inventory observation, scrutinizing for damaged or obsolete goods to confirm proper accounting.
• For an audit of a bank's loan portfolio, the substantive risk associated with loan loss provisions is significant. Factors increasing risk include the creditworthiness of borrowers and the economy. The auditor would assess the risk of misstatement in relation to the allowance for loan losses, which is calculated using estimates that are inherently uncertain. The bank’s controls around the loan provision would greatly affect the auditor’s opinion of this area.
• Evaluating substantive risk in accounts payable at a retail chain involves assessing the risk of unrecorded liabilities. Factors such as high transaction volumes and the complexity of vendor contracts can elevate this risk. If the company's procedures for matching invoices, purchase orders, and receiving reports are weak, the auditor might be more concerned. Substantive procedures, such as a search for unrecorded liabilities, are critical in these situations.
• In a charitable organization's audit, assessing substantive risk may focus on the completeness of donations. The auditor may assess the risk of fraud. This assessment is informed by the effectiveness of internal controls, such as separation of duties and donor acknowledgement procedures. If there are weaknesses, the auditor will concentrate on confirming receipts and reconciling bank deposits, and evaluating if all donations were properly recorded.