AUDIT
EVIDENCE
CHAPTER 7
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Generally accepted auditing standards
(GAAS) comprises a list of 10
standards, divided into the following
three sections:
General Standards:
1) The auditor must have adequate technical training and proficiency
to perform the audit.
2) The auditor must maintain independence in mental attitude in all
matters relating to the audit.
3) The auditor must exercise due professional care in the performance
of the audit and the preparation of the auditor's report.
2
Standards of Field Work
1) The auditor must adequately plan the work and must properly
supervise any assistants.
2) The auditor must obtain a sufficient understanding of the entity and
its environment, including its internal control, to assess the risk of
material misstatement of the financial statements whether due to
error or fraud, and to design the nature, timing, and extent of further
audit procedures.
3) The auditor must obtain sufficient appropriate audit evidence by
performing audit procedures to afford a reasonable basis for an
opinion regarding the financial statements under audit.
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Standards of Reporting
1) The auditor must state in the auditor's report whether the financial statements
are presented in accordance with generally accepted accounting principles.
2) The auditor must identify in the auditor's report those circumstances in which
such principles have not been consistently observed in the current period in
relation to the preceding period.
3) If the auditor determines that informative disclosures in the financial statements
are not reasonably adequate, the auditor must so state in the auditor's report.
4) The auditor's report must either express an opinion regarding the financial
statements, taken as a whole, or state that an opinion cannot be expressed. When
the auditor cannot express an overall opinion, the auditor should state the
reasons in the auditor's report. In all cases where an auditor's name is associated
with financial statements, the auditor should clearly indicate the character of the
auditor's work, if any, and the degree of responsibility the auditor is taking, in the
auditor's report.
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ACCUMULATING AND EVALUATING EVIDENCE
Evidence was defined in chapter 1 as:
Evidence is “ any information used by the auditor to determine
whether the information being audited is stated in
accordance with established criteria”.
Information
Criteria
Diverent types of evideces.
Highly persuasive
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Less persuasive
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CHAPTER 7 LEARNING OBJECTIVES
7-1 Contrast audit evidence with evidence used by other professions.
7-2 Identify the four audit evidence decisions that are needed to create
an audit program.
7-3 Specify the characteristics that determine the persuasiveness of
evidence.
7-4 Identify and apply the eight types of evidence used in auditing.
7-5 Know the types of analytical procedures and their purposes.
7-6 Compute common financial ratios.
7-7 Understand the purposes of audit documentation.
7-8 Prepare organized audit documentation.
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OBJECTIVE 7-1
Contrast audit evidence with evidence
used by other professions.
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NATURE OF EVIDENCE
Table 7-1 contrasts audit evidence with legal and scientific evidence.
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OBJECTIVE 7-2
Identify the four audit evidence
decisions that are needed to create
an audit program.
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AUDIT EVIDENCE DECISIONS
The auditor must make four major decisions regarding what
evidence to gather and how much to accumulate:
1. Which audit procedures to use?
2. What sample size to select for a given procedure?
3. Which items to select from the population?
4. When to perform the procedures?
An audit program includes all of the above information for a given
audit.
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Example for an audit procedures:
• Obtain the October cash disbursement journal and compare
the payee name, amount, and date on the cancelled check with
the cash disbursement journal for randomly selected sample of
50 check numbers
• An audit program is: a list for all audit procedures for a
given audit.
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OBJECTIVE 7-3
Specify the characteristics that determine
the persuasiveness of evidence.
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PERSUASIVENESS OF EVIDENCE
Audit standards require that the auditor accumulate - sufficient appropriate evidence to support the opinion issued.
The two determinants of the persuasiveness of evidence are:
i) appropriateness
and
ii) sufficiency.
I. Appropriateness of evidence depends on:
• Relevance of evidence
• Reliability of evidence
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PERSUASIVENESS OF EVIDENCE (CONT.)
• Relevance of evidence means that the evidence must pertain to or
be relevant to the audit objective that is being tested.
Accuracy : correct amount
<>
Rights and obligations Assets are owned by the firm
• Reliability of evidence refers to the degree to which evidence is believable
or worthy of trust.
Reliability depends on the following 6 characteristics:
1.
2.
3.
4.
5.
6.
Independence of provider (outside source or inside )
Effectiveness of client’s internal controls
Auditor’s direct knowledge
Qualifications of individuals providing the information
Degree of objectivity (bank st. balance <> collectability of non current A/R balances)
Timeliness
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PERSUASIVENESS OF EVIDENCE (CONT.)
II) Sufficiency of evidence refers to the quantity of evidence obtained.
The sample size that is considered sufficient is affected by two factors:
1) The auditor’s expectation of misstatements
2) The effectiveness of the client’s internal controls
• Combined Effect—The persuasiveness of the evidence can be evaluated
only after considering the combination of appropriateness and sufficiency.
• Cost benefit analyses: In making decisions about audit evidence, both
persuasiveness and cost must be considered.
The relationships among evidence decisions and persuasiveness are illustrated
in Table 7-2.
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OBJECTIVE 7-4
Identify and apply the eight types of
evidence used in auditing.
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8 TYPES OF AUDIT EVIDENCE
Every audit procedure obtains one or more of the following
types of evidence:
1.
2.
3.
4.
5.
6.
7.
8.
Physical examination
Confirmation
Inspection
Analytical procedures
Inquiries of the client
Recalculation
Reperformance
Observation
Relationships among ---auditing standards, ---types of evidence, and --- the
four audit evidence decisions are shown in Figure 7-1.
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TYPES OF AUDIT EVIDENCE (CONT.)
1. Physical Examination —The inspection or count of a tangible asset by the auditor.
2. Confirmation —The receipt of a direct written response from a third party verifying
the accuracy of information that was requested by the auditor. Information often
confirmed is detailed in Table 7-3.
3. Inspection —The auditor’s examination of the client’s documents and records to
substantiate (validate or prove ) the information in the financial statements.
• Documents can be internal (prepared by the client’s organization under a weak
or good IC system) or external (prepared or handled by someone outside the
organization who is a party to the transaction).
• Using documents to support recorded transactions (occurrence) is called
vouching.
• Testing from source documents to recorded amounts (completeness
objective) is called tracing.
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TYPES OF AUDIT EVIDENCE (CONT.)
4. Analytical Procedures —The evaluation of financial information through analysis of
reasonable relationships among financial and nonfinancial data and are required
during planning and completion phases of all audits. Purposes of analytical
procedures include:
a. Understand the Client’s Industry and Business—Used in planning to gain
knowledge about the client. (compare current year info. with the prior years client and
industry date- changes are highlighted)
b. Assess the Entity’s Ability to Continue as a Going Concern( the likelihood of failure)
-- Many ratios can be an indicator of potential financial problems.
c. Indicate the Presence of Possible Misstatements in the Financial Statements—
The presence of unusual fluctuations noted in comparing current and prior
years could signal misstatements.
d. Provide Evidence Supporting an Account Balance—If reliable relationships exist,
substantive analytical procedures can be used to support account balances.
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TYPES OF AUDIT EVIDENCE (CONT.)
5. Inquiry —Obtaining written or oral information from the client in
response to auditor questions. Usually not considered conclusive
unless it is verified.
6. Recalculation —Rechecking a sample of calculations made by the
client.
7. Reperformance —The auditor’s test of client accounting procedures
or controls.(invoice price <> approved price list . Reperform the aging of A/R)
8. Observation — (use his own senses- sight, hearing, touch, and smell) Watching a
process or procedure being performed by others.
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TYPES OF AUDIT EVIDENCE (CONT.)
Appropriateness of Types of Evidence—Table 7-4 details the criteria to
determine appropriateness.
Conclusions from the criteria:
• The effectiveness of a client’s internal controls has significant
influence on the reliability of most types of audit evidence,
especially internal documentation and analytical procedures.
• Physical examination and recalculation involve the auditor’s
direct knowledge and are likely to be highly reliable.
• Inquiry alone is usually not sufficient to provide appropriate
evidence to satisfy any audit objective.
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TYPES OF AUDIT EVIDENCE (CONT.)
Cost of Types of Evidence:
• Most expensive:
• Physical examination
• Confirmation
• Moderately costly:
• Inspection
• Analytical procedures
• Reperformance
• Least expensive:
• Observation
• Inquiries of the client
• Recalculation
Terms used in audit procedures are defined in Table 7-5.
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OBJECTIVE 7-5
Know the types of analytical procedures
and their purposes.
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ANALYTICAL PROCEDURES
Purposes of Analytical Procedures During the Audit Engagement:
1. Analytical procedures are required in the planning phase as
part of risk assessment to understand the client’s business
and industry.
2. Analytical procedures are often done during the testing phase
of the audit as substantive tests in support of an account
balance.
3. Analytical procedures are required during the completion
phase of the audit, serving as a final review for material
misstatements.
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ANALYTICAL PROCEDURES (CONT.)
Types of Analytical Procedures—Auditors compare client data with:
1. Industry data
2. Similar prior-period data
3. Client-determined expected results
4. Auditor-determined expected results
Internal comparisons and relationships are detailed in Table 7-6.
An example of a substantive analytical procedure is included in Figure 7-2.
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OBJECTIVE 7-6
Compute common financial ratios.
(8-8 p 232)
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COMMON FINANCIAL RATIOS
(8-8 p 230)
Financial ratios fall into several categories:
• Short-Term Debt-Paying Ability:(8-8 p 232)
• Cash ratio
= (Cash + Marketable security)
÷
Current Liabilities
• Quick ratio
= (Cash + Marketable security + Net A/R) ÷
Current Liabilities
• Current ratio =
Current Assets
÷
Current Liabilities
• Liquidity Activity Ratios:)The time to convert less liquid current Assets into cash)
• 1. Accounts receivable turnover
•
Days to collect receivables
• 2. Inventory turnover
•
Days to sell inventory
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=
Net sales
÷
=
365 days
÷
Average Gross Receivables
A/R Turnover
= Cost of Goods sold
÷
Average Inventory
=
÷
Inventory Turnover
365 days
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COMMON FINANCIAL RATIOS (CONT.)
Ability to Meet Long-Term Debt Obligations:
•
•
Debt to equity
=
Total Liabilities
•
Times interest earned
= Operating Income
Profitability Ratios:
•
(8-8 p 232)
÷
Total Equities
÷
Interest Expense
(8-8 p 233)
•
Earnings per share
•
Gross profit percentage =
•
Profit margin
•
Return on assets = Income Bef. Taxes - Preferred Dividends) ÷ Aver. Total Assets
•
Return on common equity = (Income Bef. Taxes - Preferred Dividends) ÷ Aver.
Stockholder’s equity
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= Net Income
=
÷
Aver. Common Shares Outstanding
(Net Sales – Cost of Goods Sold)
Operating Income
÷
÷
Net Sale
Net Sales
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OBJECTIVE 7-8
(7-5 p 188)
Prepare organized audit documentation.
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AUDIT DOCUMENTATION(7-5 P 188)
Audit documentation is the record of the audit procedures
performed, relevant audit evidence, and conclusions the auditor
reached.
Purposes of Audit Documentation:
• Basis for planning the audit
• Record of the evidence accumulated and the results of the tests
• Data for determining the proper type of audit report
• Basis for review by supervisors and partners
Ownership of the Audit Files: All audit files are the property of
the auditor.
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AUDIT DOCUMENTATION (CONT.)
 Confidentiality of Audit Files:
(7-5 p 189)
The AICPA Code of Professional Conduct states that a member in public practice
shall not disclose any confidential client information without the specific
consent of the client.
 Requirements for Retention (holding) of Audit Documentation:
a. Auditing standards require records of private companies be retained for
a minimum of five years.
b. Sarbanes-Oxley Act requires auditors of public companies to maintain
audit files for a minimum of seven years.
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AUDIT DOCUMENTATION (CONT.)
The contents and organization of a typical set of audit files is illustrated in Figure 7-3. (7-2 p
190)
The type of audit documentation and the way it is arranged in the files is logical although
firms may vary in their approaches.
Permanent Files: Contain data of a historical or continuing nature. These provide a
convenient source of information that is used from year to year:
• Copies of company documents such as articles of incorporation, bylaws, bond indentures,
and long-term contracts
• Analyses of accounts from previous years that have continuing importance
• Information related to understanding internal controls and assessing control risk
• Results of analytical procedures from prior years’ audits for comparison
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(Figure 7-2
p 190)
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AUDIT DOCUMENTATION (CONT.)
Current Files: Includes all documentation for the current year audit
including:
• Audit Program
(7-5
• Working Trial Balance—Each line in the trial balance is supported by a
lead schedule. A typical lead schedule for Cash is included in Figure 7-4.
• Adjusting Entries—Auditors propose adjusting entries for material
misstatements. An adjusting entry to Cash is illustrated in Figure 7-4.
• Supporting Schedules—Major types:
• Analysis
• Trial balance or list
• Reconciliation of amounts
• Substantive analytical procedures
• Summary of procedures
• Examination of supporting documentation
• Informational
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• Outside documentation
p 191)
(Figure 7-3
p 192)
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(Figure
7-4
p 193)
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AUDIT DOCUMENTATION (CONT.)
(7-6 p 195)
Preparation of Audit Documentation —Audit documentation should be
in sufficient detail to provide a clear understanding of the work
performed, evidence obtained, and conclusions reached.
Documentation should have these characteristics:
• Identified with the client’s name, period covered, description of the
contents, initials of the preparer, date of preparation, and an index
code.
• Files should be indexed and cross-referenced to aid in organization.
• Documentation should clearly indicate the audit work performed
through memos, initialing the procedures in the audit program, or tick
marks on the schedules.
• Include sufficient information to fulfill the audit objectives.
• Conclusions reached about the segment of the audit should be clearly
stated.
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