Chapter 7
Audit Evidence: A Framework
for Directly Testing Account
Balances and Transactions
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
Define the 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
Review Gathering Sufficient,
Competent 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 control structure
 Current market conditions and competitor
actions
List the Steps in the Overall
Audit Process
1. Understand the client and
industry
2. Assess environment risk
3. Directly test transactions
and/or account balances
4. Assess adequacy of evidence
Discuss Sufficient, Competent
Evidence
There are two dimensions to audit evidence: sufficient
(quantity) and competent (quality/reliability)
The relationship between these dimensions is inverse: if
evidence is of lesser quality, greater amounts must be
collected (and vice versa)
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:
 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
Comment on 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
Comment on 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
Discuss 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
What is 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
More Nature of Audit Testing
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
Even More Nature of Audit
Testing
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
Discuss 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 or other
business measurements
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
Audit Procedures: Understand
and Test System
For all systems:
 Inquire of management and employees
 Review system documentation
 Observe system in operation
 Document system flow and control points
 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 or Other Business
Measurements
Direct tests of account balances:
Review authoritative records and documents
Examine client-retained documentation
Examine outside documentation
Examine electronic records
Testimonial evidence:
Inquire of client personnel
Inquire of and analyze responses from
outside parties
Audit Procedures: Test Account
Balances or Other Business
Measurements (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
Discuss 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)
Discuss Evidence-gathering
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
 Physical examination of assets
 Inquiry
 Confirmations
 Examination of documents
 Re-computation of data
 Reprocessing transactions
 Vouching transactions
 Analytical procedures
Review Evidence-gathering
Procedures
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
Review Evidence-gathering
Procedures (continued)
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)
Review Evidence-gathering
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 evidence
Confirmations
 Auditor sends letter to outside party asking them to verify
client information
 Considered strong evidence because they come from external
parties
 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
Review Evidence-gathering
Procedures (Continued)
Evidence-gathering 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
Review Evidence-gathering
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)
Review Evidence-gathering
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
Comment on Timing of Audit
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
Comment on Timing of Audit
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)
Discuss Extent of Audit
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
What are audit programs?
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
What is 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
What are 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
 Tick marks and legend indicating work performed by
the auditor
 Index to identify the location of papers
 Cross-reference to related documentation, when
applicable
Importance of Quality Review
Audits of corporations subject to SEC
regulation must be subjected to a
concurring partner review before the
audit report is issued
The concurring partner should not be
involved in the audit, but should have
knowledge of the client's business and
industry