Audit Evidence and

Documentation

Chapter 05

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

5-2

Audit Risk

The possibility that the auditors may

unknowingly fail to appropriately modify their

opinion on financial statements that are

materially misstated

This is the risk that the auditors will issue an

unqualified opinion on financial statements that

contain a material departure from GAAP.

Auditors must obtain sufficient appropriate audit

evidence to reduce audit risk to a low level in

every audit.

5-3

Financial Statement Assertions

Relevant assertions are those that, without

regard for controls, have a reasonable

possibility of containing a material

misstatement; types

Assertions about account balances

(Accounts)

Assertions about classes of transactions and

events (Transactions)

Assertions about presentation and disclosure

(Disclosures)

5-4

Financial Statement Assertions: Auditing

Standards Board and International Standards

Accounts Transactions Disclosures

Existence Occurrence Occurrence

Rights and

obligations

Rights and

obligations

Completeness Completeness Completeness

Valuation and

allocation

Accuracy Accuracy and

valuation

Cutoff

Classification Classification and

understandability

5-5

Combined Assertions

Used in this Text Existence or Occurrence--Assets, liabilities, and equity

interests exist and recorded transactions have occurred

Rights and Obligations--The company holds rights to the assets, and liability are the obligations of the company

Completeness--All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded

Cutoff—Transactions and events have been recorded in the correct accounting period

Valuation, Allocation and Accuracy—All transactions, assets, liabilities and equity interests are included in the financial statements at proper amounts

Presentation and Disclosure--Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressed

5-6

Audit Risk

Risk of Material Risk That the Audit Risk = Misstatement * Auditors Fail to the Misstatement = Inherent Control Detection Risk * Risk * Risk Inherent Risk--Risk of a material misstatement occurring in an

assertion assuming no related internal controls.

Control Risk--Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control.

Detection Risk--Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.

5-7

Audit Risk Formula

AR = IR * CR * DR

AR = Audit risk

IR = Inherent risk

CR = Control risk

DR = Detection risk

5-8

Audit Risk

Figure 5. 2

5-9

Inherent Risk

Factors that affect inherent risk:

Nature of the client and its environment

Nature of the particular financial statement element

Business characteristics indicative of high inherent risk:

Inconsistent profitability of client

Operating results highly sensitive to economic factors

Going concern problems

Large known and likely misstatements detected in prior audits

Substantial turnover, questionable reputation, or inadequate

accounting skills of management

5-10

Assertions with high

inherent risk Involve:

Difficult to audit transactions or balances

Complex calculations

Difficult accounting issues

Significant judgment by management

Valuations that vary significantly based on

economic factors

5-11

Types of Transactions

Routine

Recurring financial statement activities recorded in the

accounting records in the normal course of business

Lower inherent risk

Nonroutine

Involve activities that occur only periodically such as the taking

of physical inventories

High inherent risk

Estimation transactions

Activities that create accounting estimates

Higher inherent risk

5-12

Appropriateness of Audit Evidence0

Auditor must obtain sufficient appropriate audit evidence.

To be appropriate audit evidence must be: Relevant Reliable

Principles—Audit evidence is ordinarily more reliable when it is Obtained from knowledgeable independent sources outside

the company rather than nonindependent sources Generated internally through a system of effective controls

rather than ineffective controls. Obtained directly by the auditor rather than indirectly or by

inference Documentary in form rather than oral Provided by original documents rather than copies

5-13

Reliability of Certain Types of

Audit Evidence

RELIABILITY TYPE EXAMPLE

High Physical Inventory Observation

Documentary

External Cutoff Bank Statement

External/Internal Purchase Invoice

Internal Sales Invoice

Low Client Representations Management Representation

Letter

5-14

Types of Audit Evidence

1. Accounting information system

2. Documentary evidence

3. Third-party representations

4. Physical evidence

5. Computations

6. Data interrelationships

7. Client representations

5-15

Common Audit Procedures

5-16

Overall Types of Audit Procedures

Risk assessment procedures To obtain an understanding of the client and its

environment, including its internal control, to assess the risks of material misstatement

Further Audit Procedures Tests of controls

When appropriate, to test the operating effectiveness of controls in preventing material misstatements

Substantive procedures To detect material misstatements at relevant assertion level.

Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosures

5-17

Substantive Procedures

Analytical procedures

Tests of details • Tests of account balances

• Tests of classes of transactions

• Tests of disclosures

One may change the scope of audit

procedures by changing the (NTE, or re-

ordered as NET):

• Nature (type and form)

• Timing (when performed)

• Extent (quantity of evidence obtained)

5-18

Nature and Timing of Procedures

Holding the extent of procedures constant,

one may increase the scope of procedures

(make them more effective) by either

changing the Nature-- obtain more reliable evidence

• often externally generated evidence.

Timing--wait until year-end to obtain evidence from

entire set of transactions as contrasted to performing

interim testing, say two months prior to year-end and

simply updating those procedures.

5-19

Extent of Procedures

Holding other factors such as the nature

and timing of procedures constant:

The greater the risk of material misstatement,

the greater the needed extent of substantive

procedures

The main way to increase the extent of audit

procedures is to examine more items

Sample sizes should reduce detection risk so

as to restrict audit risk to a low level

5-20

General on Analytical

Procedures (1 of 3) Timing of analytical procedures

Risk assessment (sometimes referred to as planning analytical procedures)

Substantive procedures

Final review

Steps involved Develop expectation of account (or ratio) balance

Determine amount of difference that can be accepted without investigation

Compare the company’s account (ratio) with the expectation

Investigate and evaluate significant differences

5-21

General on Analytical

Procedures (2 of 3) Developing an expectation

Prior period information

Anticipated results

Relationships among elements of financial information within a period

Industry information

Relationships between financial information and relevant nonfinancial data.

5-22

General on Analytical

Procedures (3 of 3) Types of Expectations

Trend analysis—analyze changes in accounts of a

company over time

Ratio analysis – compare relationships between two

or more financial statement accounts or comparisons

of account balances to nonfinancial data

• Liquidity (e.g., current ratio)

• Leverage (e.g., debt to equity)

• Profitability (e.g., gross profit percentage)

• Activity (e.g., inventory turnover)

5-23

Ratio Analysis

Approaches to ratio analysis

Horizontal analysis

• Review ratios over time

Cross sectional analysis

• Analyze ratios of similar firms at a point in time

Vertical analysis • Analyze relationships within a period

• ―Common size‖ statements prepared

Other methods

• Regression analysis, reasonableness test

5-24

Identifying Potential Misstatements

5-25

Basic Approaches to Auditing

Accounting Estimates

Review and test management’s process for developing the estimate.

Independently develop an estimate to compare to management’s estimate.

Review subsequent events or transactions bearing on the estimate.

5-26

Auditing Fair Values

Inputs to use in applying valuation techniques (FAS 157)

Level 1 – inputs of observable quoted prices in active markets for identical assets or liabilities

• Ex. A closing stock price in WSJ

Level 2 – inputs of observable quoted prices, generally for similar assets or liabilities in active markets

• Ex. Company discounts future cash flows on its not publicly traded debt securities at rate used by market for publicly traded debt securities

Level 3 – inputs that are unobservable for the assets or liability

• Ex. A private company uses judgment to determine a proper rate to discount the future cash flows of its not publicly traded securities

5-27

Related Party Transactions

Disclosure requirements must be met

Primary challenge is identifying

undisclosed related party transactions

Determine related parties

• Inquiries of management

• Review SEC filings, stockholder’s listings and

conflict-of-interest statements

Be alert for transactions with related parties

and any transactions with unusual terms

5-28

Functions of Audit Documentation

Primary functions: •Support the auditors’ compliance with auditing standards

•Support the auditors’ opinion

Secondary functions: •Assist continuing and new audit team members in planning and performing the audit

•Serves as a record of matters of continuing audit interest

•Assists in supervision and review of the audit

•Demonstrates the accountability of team members

•Assists internal reviewers, external peer reviewers, PCAOB inspectors, and successor auditors in performing their roles

5-29

Sufficiency of Audit Documentation

Audit documentation should be sufficient to: Enable an experienced auditor to understand the

work performed and the significant conclusions reached

Identify who performed and reviewed the work

Show that the accounting agree or reconcile to the financial statements

Audit documentation should include all significant audit findings and the actions taken to address them

5-30

Types of Working Papers

Audit administrative working papers

Working trial balance

Lead schedules

Adjusting journal entries and reclassification entries

Supporting schedules

Analysis of a ledger account

Reconciliations

Computational working papers

Corroborating documents

5-31

Types of Working Files

Current files

Current year working papers

Index and cross-referencing

Permanent files

Items of continuing audit

interest

5-32

5-33

Preparation of a Working Paper –

Figure 5.8