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Audit Evidence: A Framework for Directly Testing Account Balances and Transactions

Chapter 7

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OverviewAuditing 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

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Overview (continued) The evidence gathering process is the

core of the audit; evidence is needed toReduce audit riskSupport the opinion

In deciding which evidence to gather, the auditor considersRisk associated with an account balance or

other measures of performanceTypes of evidence availableReliability of alternative sources of evidence

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Third General Standard of FieldworkSufficient, 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

The auditor gathers evidence to evaluate the management assertions embodied in the financial statements and individual accounts.Existence or occurrence

CompletenessRights and obligationsValuation or allocationPresentation and disclosure

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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 integrityClient economic riskQuality of client's information systemClient's control structureCurrent market conditions and competitor

actions

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Sufficient, Competent Evidence (Cont’d)

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

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Reliability

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

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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

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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

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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

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The nature of audit testingWhen 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

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Nature of Audit Testing (Cont’d)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

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Nature of Audit Testing (Cont’d) 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 balanceReliable forms of evidence are often available

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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 Understanding and testing the system Test account balances or other business

measurements

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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

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Audit Procedures: Understanding and Testing the 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

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Audit Procedures: Test Account Balances or Other Business Measurements

These are discussed in the following slides entitled: Evidence-gathering 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

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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 these procedures

The primary types of audit procedures include:1. Observation of client personnel and procedures2. Physical examination of assets3. Inquiry4. Confirmations5. Examination of documents6. Re-computation of data7. Reprocessing transactions (Tracing)8. Vouching transactions9. Analytical procedures

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Evidence-gathering Procedures1. Observation of client personnel and

proceduresMost often used to gain an understanding of

client processing systemAlso used to observe counting of physical

inventoryLimitations:

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

differently; this makes it difficult to generalize the evidence obtained

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Evidence-gathering Procedures (continued)

2. Physical examination of assetsUseful in verifying existence of tangible assetsMay be useful in identifying potential

obsolescence or wear and tearDoes not provide evidence on completeness,

ownership, or proper valuation (except as in item above)

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Evidence-gathering Procedures (Continued)

3. Inquiry Used extensively, especially early in the audit

to gain an understanding Efficient way to gather evidenceNot considered persuasive, should be

corroborated by other sources of evidence

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Evidence-gathering Procedures (Continued)

4. 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

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5. Examination of documents Much of the audit process involves examining

documentsUseful for evaluating all of the assertionsAuditor should establish document

authenticity in order to rely on it

Evidence-gathering Procedures (Continued)

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Evidence-gathering Procedures (Continued)

6. Recalculation (Re-computation) Includes footing, cross-footing, tests of

extensions, re-computationOften used to test accuracy of estimated

accounts and allowances

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Test of transactions involve reconciling source documents with recorded accounting information

7. Reprocessing (Tracing) 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)

Evidence-gathering Procedures (Continued)

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8. Vouching Reverse of reprocessing (Tracing)Select sample of already recorded

transactions and trace back to the underlying source documents

Helps establish that recorded transactions are valid (existence)

Evidence-gathering Procedures (Continued)

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Evidence-gathering Procedures (Continued)

9. Analytical Procedures (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

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Directional Testing (Audit Efficiency) Directional testing:

auditor tests for over- or understatement, not both at the same time. 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 (sales

receivables) accounts Some management assertions are directional by nature

(existence addresses overstatement; completeness, understatement)

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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

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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)

Timing of Audit Procedures (Cont’d)

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Extent of Audit ProceduresIn 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 (Over/under auditing)

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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 workMonitoring the audit processRecording audit work performedReviewing the audit procedures performed

and evidence gathered

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Documenting audit evidenceThe 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

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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

Working papers

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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

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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