Chapter 7

Audit Evidence:

A Framework

Copyright © 2010 South-Western/Cengage Learning

Audit Opinion Formulation Process

Overview

• Auditing is a process of objectively gathering, evaluating,

and documenting the evidence needed to provide assurance on the financial statements

• In planning an audit, three questions need to be answered:

– What audit procedures should be performed?

– How much evidence is needed?

– When should the audit procedures be performed?

The audit programs detail the auditor's plan to gather, evaluate, and

document evidence

Overview (continued)

• The evidence gathering process is the core of the audit; evidence is needed to– Reduce audit risk

– Support the opinion

• In deciding which evidence to gather, the auditor considers– Risk associated with an account balance or other measures

of performance

– Types of evidence available

– Reliability of alternative sources of evidence

LO 1 Third Standard of Fieldwork

Sufficient, competent evidential matter is to be obtained through audit procedures performed to afford a reasonable basis for an opinion regarding the financial statements under audit

What is the assertion model?

• The auditor gathers evidence to evaluate the management assertions embodied in the financial statements and individual accounts

• Existence or occurrence

• Completeness

• Rights and obligations

• Valuation or allocation

• Presentation and disclosure

LO 3 Gathering Sufficient, Appropriate Evidence

• Because each audit is unique, there is no set amount or type of evidence that must be gathered

• When considering the best approach to gather evidence, the auditor needs to consider factors affecting the reliability of the financial data:

– Management integrity

– Client economic risk

– Quality of client's information system

– Client's internal controls

– Current market conditions and competitor actions

The Steps in the OverallAudit Process

1. Understand the client and industry

2. Assess environment risk

3. Test details of transactions and/or

account balances

4. Assess adequacy of evidence

Sufficiency

• Evidence must be convincing and of sufficient quantity to convince the audit team of the correctness or incorrectness of an account balance.

• When gathering evidence, auditors consider which procedures provide the most reliable evidence in the most efficient manner

• Reliability depends on the circumstances under which evidence is gathered:

Sufficiency (continued)

– Evidence obtained from independent outside sources is more reliable than evidence obtained from the client

– Evidence obtained from auditor's direct knowledge is more reliable than evidence obtained indirectly

– Evidence obtained from client with strong internal controls is more reliable than evidence obtained from client with weak internal controls

Internal Documentation

Reliability varies with

– Quality of client's internal controls

– Management's motivation to misstate (fraud potential)

– Formality of the documentation including acknowledgement by independent parties

– Preparation of the document independently of the accounting system and management

External Documentation

• Generally considered highly reliable

• External documents provided by a client should be viewed more critically than documents received directly from the external party

Paper vs. Electronic Documentation

• Major challenge for auditors to determine which electronic data is reliable

• Computer systems can be designed to provide safeguards similar to paper-based systems

• If auditor is going to rely on electronic data, he/she must develop an understanding of the

– Client's computer system

– Controls used to safeguard electronic data from manipulation or destruction

The Nature of Audit Testing

• When directly testing an account balance or

transactions, the auditor examines two basic

types of evidence

– The underlying accounting data and records

– Corroborating information that validates the

underlying accounting data

The Nature of Audit Testing (continued)

• Auditors have traditionally used direct tests of year-end account balances, as opposed to examining the transactions that make up the account balance

Generally,– There are usually fewer items in the ending

balance than the number of underlying transactions during the year

– More reliable evidence usually exists for an ending balance than for the underlying transaction

The Nature of Audit Testing (continued)

• However, for many long term accounts (assets, liabilities, owners' equity), the auditor may focus on the transactions that occurred during the audit period

• For these accounts, – There are usually fewer transactions during the

year than items in the ending balance– Reliance forms of evidence are often available

Audit Procedures

• The procedures an auditor will use vary according to the risks associated with the client and the methods used to record transactions.

• Three major phases of the audit:– Preliminary planning and risk analysis– Understand and test system– Test account balances and transactions

Audit Procedures: Preliminary Planning and Risk Analysis

• Review prior-year audit work

• Review publicly available data about the organization

• Perform analytical procedures

• Inquire of management and employees

• Perform internal control walkthroughs

Audit Procedures: Understand and Test the System

For all systems:– Inquire of management and supervisory personnel– Review system documentation– Observe system in operation– Document system flow and control points– Determine the effectiveness of procedures– Select transactions and trace through processing

Additional work for computerized systems:– Test important computer controls– Use computer software to trace transactions through system– Use software to select transactions for further verification

Audit Procedures: Test Account Balances and Transactions

• Review authoritative records and documents– Vendor invoices and monthly statements– Receiving and shipping records– Legal documents and others

• Testimonial evidence:– Inquire of client personnel– Inquire of outside parties

Audit Procedures: Test Account Balances and Transactions (continued)

• Auditor-generated evidence:– Direct observation– Perform re-computations– Reprocess transactions from source documents to accounting

records– Vouch transactions from accounting records back to source

documents– Physically examine assets– Perform analytical procedures

• Each of these procedures has strengths and weaknesses; the auditor's task is to determine which procedures provide a sufficient level of evidence with the least amount of audit cost

LO 4 Directional Testing (Audit Efficiency)

• Directional testing: auditor tests for over- or understatement, not both Increases audit efficiency– Misstatements are more likely to occur in one direction

(assets and revenues overstated, liabilities and expenses understated)

– With directional testing, auditor uses procedures that focus on the most likely misstatements

– Vouching and reprocessing are examples of directional tests

– Can also provide evidence about complementary accounts– Some management assertions are directional by nature

(existence addresses overstatement; completeness, understatement)

LO 5 Commonly Used Audit Procedures

• Auditors use a variety of procedures to gather evidence

• For certain accounts or management assertions, certain procedures may be more efficient or effective than other procedures

• When writing audit programs, the auditor tries to use those procedures

• The primary types of audit procedures include:– Observation of client personnel and procedures

LO 5 Commonly Used Audit Procedures (continued)

– Physical examination of assets– Inquiry– Confirmations– Examination of documents– Re-computation of data– Reprocessing transactions– Vouching transactions– Analytical procedures

Commonly Used Audit Procedures (continued)

Observation of client personnel and procedures– Most often used to gain an understanding of client

processing system– Also used to observe counting of physical

inventory– Limitations:

• Intrusive and time-consuming• Employees know they're being watched and act

differently; this makes it difficult to generalize the evidence obtained

Physical examination of assets

– Useful in verifying existence of tangible assets

– May be useful in identifying potential obsolescence or wear and tear

– Does not provide evidence on completeness, ownership, or proper valuation (except as in item above)

Commonly Used Audit Procedures (continued)

Inquiry – Used extensively, especially early in the audit to gain

an understanding – Efficient way to gather evidence– Not considered persuasive, should be corroborated by

other sources of evidenceConfirmations – Auditor sends letter to outside party asking them to

verify client information– Considered strong evidence because they come from

external parties

Commonly Used Audit Procedures (continued)

– Limitations: • Respondents may not adequately check information

being confirmed• Respondents may not respond in a timely fashion• Respondents may not challenge figures in their favor

Commonly Used Audit Procedures (continued)

Examination of documents – Much of the audit process involves examining documents

– Useful for evaluating all of the assertions

– Auditor should establish document authenticity in order to rely on it

Recalculation – Includes footing, cross-footing, tests of extensions, re-

computation

– Often used to test accuracy of estimated accounts and allowances

Commonly Used Audit Procedures (continued)

Test of transactions involve reconciling source

documents with recorded accounting information

Reprocessing – Select sample of source documents and reprocess them to

make sure they have all been properly recorded

– Includes reviewing journalizing and posting of the transaction

– Helps establish completeness (all valid items have been recorded)

Commonly Used Audit Procedures (continued)

Vouching – Reverse of reprocessing

– Select sample of already recorded transactions and trace back to the underlying source documents

– Helps establish that recorded transactions are valid (existence)

Analytics – Compare recorded account balances (or ratios of balances)

to expectations developed by the auditor

– Sources used to develop these expectations include client's prior period information, industry data, expected results

Commonly Used Audit Procedures (continued)

Timing of Procedures

In addition to what procedures to perform, the auditor

must also decide when to perform them– As of the balance sheet date

– After the balance sheet date

– Before the balance sheet date (interim testing)

Advantages of interim testing:– Audit may be completed, and statements distributed,

sooner

– Typically means less overtime for audit staff

Timing of Procedures (continued)

Disadvantages of interim testing:– Risk of material misstatement between interim date and

year-end

Interim testing is feasible:– When client has strong internal controls

– When there is low probability of significant change in account balances between interim work and year-end

– For accounts in which the auditor focuses on tests of transactions rather than the year-end balance (example: non-current assets)

Extent of Procedures

In addition to deciding what procedures to perform and when to

perform them, the auditor must also decide how much evidence is

needed

The extent of testing is affected by:– Auditor's assessment of the risk of account balance misstatement

– Amount of misstatement considered material

– Persuasiveness of alternative forms of evidence

The amount of evidence may also be influenced by the auditor's individual risk preferences

LO 6 Audit Programs and Documenting Audit Evidence

• Audit programs specify the audit objectives and procedures used to gather, document, and evaluate evidence

• Audit programs guide the conduct of the audit and provide an effective means for:– Organizing and distributing audit work

– Monitoring the audit process

– Recording audit work performed

– Reviewing the audit procedures performed and evidence gathered

LO 7 Documenting Audit Evidence

The audit work papers include all forms of documentation including:

– Evidence of planning, including audit programs– The client's trial balance and any auditor adjustments– Copies of selected internal and external documents

including confirmation and representation letters and abstracts of company documents

– Schedules prepared or obtained by the auditor– Auditor memos– Results of analytical procedures and tests of client records– Auditor analysis of account balance

Audit programs

• The work papers are the primary evidence in support of audit conclusions and should cover all relevant audit work, support the audit report, and leave no significant points unresolved

• The work papers aid in the conduct and supervision of the work, facilitate performance of an effective review, demonstrate adherence to professional and Firm auditing standards and procedures, and assist in planning the following year's audit

Characteristics of Good Audit Documentation

Well-developed audit documentation contains:– A heading that includes client name, explanatory

title, and balance sheet date– Initials of the auditor who prepared the

documentation and date completed– Initials of the reviewer and date review completed– Description of the tests performed and the findings– Assessment of whether tests indicate material

misstatement in an account

Characteristics of Good Audit Documentation (continued)

– Tick marks and legend indicating work performed by the auditor

– Index to identify the location of papers– Cross-reference to related documentation, when

applicable

LO 8 Auditing Account Balances Affected by Management’s Estimates

• Account balances are based on information gathered related to making estimates, appraisals, or other management assumptions

• These accounts include– Estimated warranty liability

– Evaluation of fixed assets

– Analysis of goodwill

• Evidence used in Auditing Management’s Estimates– Auditors should evaluate the processes used by

management in making estimates