Auditors examine a company’s financial statements and related matters to form an independent opinion. This opinion concludes that these statements are free from any material misstatements. For that, auditors need to have a basis, which comes from audit evidence collected during audits. This evidence needs to be sufficient and appropriate for auditors to reach a correct conclusion.
Auditors can use several techniques to gather audit evidence. However, they must use their professional judgment to determine whether this evidence is sufficient and appropriate. For each financial statement item, the audit approach to collect audit evidence will differ. One such technique is using directional testing. However, this technique has become obsolete according to auditing standards.
What is Directional Testing?
Directional testing is a technique used by auditors in the past to collect evidence. First developed in the early 1980s, directional testing depends on the fundamentals of financial accounting. This technique uses the double-entry concept to cover all aspects of the audit engagement. Through that, it reduces the number of items that auditors use during their audit assignments.
In short, directional testing is an auditing technique based on double-entry principles. It assumes that if auditors examine a transaction’s debit side, they can skip its credit side. This way, it makes the audit process shorter and easier. Directional testing suggests that auditors don’t need to look at both sides of a transaction. Instead, they can test one side, which assumes the other side is also correct.
Directional testing suggests that by testing only one side of an entry, auditors can avoid over-auditing. Similarly, it assumes that auditors can remove duplication from their work by following this approach. However, auditors need to use directional testing from the start of a transaction cycle till the end. If they fail to do so, it will not be effective.
How Does Directional Testing Work?
In essence, directional testing is an audit approach that can help auditors design and implement audit procedures. Like any other audit procedure, directional testing can help auditors identify risk areas. Similarly, it clarifies audit objectives and links together test results. In short, it provides a framework for conducting an audit engagement.
Directional testing has become obsolete and deprecated for its limitations in modern auditing standards. It works on the double-entry concept, suggesting that every debit entry must have an equal credit side. It assumes that if a trial balance matches up, but there is a misstatement on the debit side, then there will also be another misstatement to compensate for it.
Auditors test debit entries for overstatement and credit entries for understatement. It is in line with the prudence concept, which suggests that companies should not overstate assets or understate liabilities. Therefore, when testing assets or expenses directly for overstatement, auditors also indirectly test liabilities, equity, and revenues for overstatement. It also applies the other way round.
In practice, auditors may use accounts receivable and sales for directional testing. When auditors test account receivables for overstatement directly, they also test sales indirectly for overstatement. The same applies to accounts payable balances and purchases or expense transactions. Apart from these, directional testing may also have some other use cases.
What are the Objectives of Directional Testing?
As mentioned above, directional testing seeks to avoid any duplication in auditors’ work. It ensures that auditors don’t over-audit and make the process shorter. As stated above, directional testing assumes that auditors test both sides of a transaction when checking one side. Therefore, when they test one side directly, they are also testing the other side indirectly.
Directional testing also relates to ascertaining that auditors cover all areas of an audit. It ensures that they do so in the simplest and most cost-effective way possible. Auditors can also test various assertions during the process. For example, when testing for understatements, auditors also test for completeness. Similarly, testing for overstatement allows them to evaluate valuation, existence, rights and obligations, and occurrence.
What is an Example of Directional Testing?
An auditor identifies a company that has overstated its fixed assets by $10,000 and is a debit balance. Therefore, it suggests that there will also be another misstatement in the financial statements of the same amount. Hence, the company’s liabilities, equity, or revenues will be overstated, or another asset or expenses understated.
Therefore, when auditors test the balance directly for overstatement, they also check the corresponding misstatement indirectly. It is the basic premise of directional testing. If the auditor examines the corresponding misstatement directly, they also test the overstated fixed assets indirectly. When checking for overstatements, auditors examine whether the transaction has occurred at the first point. When assessing understatements, auditors check whether the client has recorded all transactions.
Conclusion
Directional testing is an audit procedure that auditors can use during their engagements. It uses the double-entry concept to help auditors with their audits. Directional testing aims to reduce the time it takes auditors to complete their audits. Similarly, it ensures that they conduct their audits cost-effectively. However, this technique has become obsolete by auditing standards.
