Auditor gathers sufficient appropriate audit evidence to reduce audit to an acceptably low level and also the same audit evidence enables the auditor to reach reasonable conclusions which form the basis of auditor’s opinion.
Now to gather sufficient appropriate audit evidence, auditor has to select the appropriate audit approach or audit methodology that promises the achievement of audit objective within the given constraints and circumstances. One of the audit approach is directional testing.
Directional testing has its roots connected directly in the financial accounting basics. We can understand how much double entry system is essential in financial accounting. Directional testing is an auditing technique that has based the same principle to audit the financial statements. As we understand for every debit “effect” in books of account there must be a credit effect with the equal amount. Thus if trial balance is agreeing and the debits are correctly done, then more chances are that credits are also done correctly. So, if auditor confirms the debit amounts then corresponding credit amount will be checked also. And thus we may have the chance to kill two birds with one stone.
Mr. A bought some goods worth 14,000.
This will be recorded in his books as:
Purchases a/c 14,000
to Cash a/c 14,000
Now, lets assume for a second that its the only entry in his books then his trial balance will be debit 14,000 and credit 14,000. In this situation if auditor checks for understatement or overstatement in Purchases and finds that Purchases account is OK then even if he has not checked Cash account, he has automatically confirmed that Cash account is also correct. And if Purchases account is overstated or understated then as trial balance are equal then Cash account will also be overstated or understated respectively.
As we will be examining only one side or one direction of the transaction at a time i.e. either debit or credit hence we get the name directional testing. And after selecting the direction we look for either overstatement or understatement in the account balances.
When we look for overstatements, we are basically checking whether the transaction actually occurred at first point or not because if transaction has not occurred and still has been recorded then it will surely cause overstatement in one account and understatement or overstatement in other account or accounts depending on the types of accounts getting affected by the transaction.
When we look for understatements, we are basically checking whether all the transactions have been recorded or not because of the transaction has occurred and has not been recorded then it will cause an understatement in one account and understatement or overstatement in another account or accounts depending on the types of accounts getting affected by the transaction.
One thing more on how overstatement and understatement tests are carried out. When auditor wants to check for overstatement then basically he wants to check occurrence so he will have to work back from the ledger to the very source document that evidences the transaction’s occurrence. Whereas, while checking for understatements, he basically wanted to confirm that all the transactions have been recorded. For this he will start from the source document and will work forward until he reaches the ledger in which the transaction should be recorded. This might be just another reason why this technique has the name directional testing.
Have a look at the following figures to best understand how the procedures take place. Remember, following figures are neither a universal way of maintaining records nor every audit is conducted in this fashion but most often this is the case.