Chapter 5 Evidence and Documentation

Relationship of Audit Evidence to the Audit Report Financial statements Audit report Management assertions about elements of financial statements Auditor reaches a conclusion based on the evidence Audit procedures Provide evidence on the fairness of the financial statements

Management Assertions Completeness Occurrence Classification Assertions about classes of transactions and events for the period under audit Cut-off Accuracy Authorization

Management Assertions Existence Completeness Assertions about account balances at the period end Valuation and allocation Rights and obligations

Management Assertions Occurrence and rights and obligations Completeness Assertions about presentation and disclosure Accuracy and valuation Classification and understandability

Management Assertions Table 5–2 Summary of Management Assertions by Category (continued)

Management Assertions

All the information, from Audit Evidence All the information, from whatever source, used by the auditor in arriving at the conclusions on which the audit opinion is based.

The Concepts of Audit Evidence Nature of audit evidence Sufficiency and appropriateness of audit evidence Evaluation of audit evidence

Nature of Audit Evidence Records of initial entries and supporting records General and subsidiary ledgers Spreadsheets supporting cost allocations Minutes from meetings Benchmarking Invoices Analyst’s reports Worksheets Contracts Other computations, reconciliations and disclosures Information obtained from audit procedures Adjustments to financial statements

Sufficiency of Audit Evidence Sufficiency is a measure of the quantity of audit evidence. Greater risk of misstatement requires a higher quantity of audit evidence. Higher quality audit evidence results in a lower quantity of audit evidence.

Appropriateness of Audit Evidence Relevance Appropriateness is a measure of the quality of audit evidence. Reliability Original documents Documentary evidence Effectiveness of internal control Independent source outside the entity Auditor’s direct personal knowledge

Evaluation of Audit Evidence Proper evaluation of evidence requires an understanding of the: Relative reliability of available evidence. Types of evidence available. An auditor should be thorough in searching for evidence and be unbiased in its evaluation.

Audit Procedures Specific acts performed by the auditor to gather evidence about whether specific assertions are being met. Risk assessment procedures Test of controls Substantive procedures

Audit Procedures The set of audit procedures prepared to test assertions for an element of the financial statements is described in the audit plan. Audit Plan for Accounts Receivable Management Assertions Example Audit Procedures Existence Confirm accounts receivable. Rights and obligations Inquire of management whether receivables have been sold. Completeness Agree total of accounts receivable subsidiary ledger to accounts receivable control account. Valuation or allocation Test the adequacy of the allowance for doubtful accounts.

Audit Procedures for Obtaining Audit Evidence Inspection of records or documents Inspection of tangible assets Observation Inquiry External Confirmation Recalculation Reperformance Analytical procedures Scanning

Audit Procedures for Obtaining Audit Evidence Inspection of records or documents Evidence obtained from external documents is more reliable than evidence obtained from internal documents. Journal or Ledger Source Documents Vouching (Occurrence) Tracing (Completeness)

Audit Procedures for Obtaining Audit Evidence Inspection of tangible assets Physical examination of a tangible asset. Observation The process of watching a process or procedure being performed by others.

Audit Procedures for Obtaining Audit Evidence In conducting inquiry, the auditor should: Consider the knowledge, objectivity, experience, responsibility and qualifications of the person to be questioned. Ask clear, concise and relevant questions. Use open or closed questions appropriately. Listen actively and effectively. Consider the reactions and responses, and ask follow-up questions. Evaluate the response. Inquiry

Audit Procedures for Obtaining Audit Evidence External Confirmation The process of obtaining a representation of information of an existing condition directly from a third party. The reliability of evidence obtained through confirmations is directly affected by factors such as: The form of the confirmation. Prior experience with the entity. The nature of the information being confirmed. The intended respondent.

Audit Procedures for Obtaining Audit Evidence External Confirmation 21

Audit Procedures for Obtaining Audit Evidence Recalculation Determining the mathematical accuracy of documents or records. Reperformance The auditor’s independent execution of procedures or controls that were originally performed by company personnel.

Audit Procedures for Obtaining Audit Evidence Analytical procedures Evaluations of financial information made by a study of plausible relationships among both financial and non-financial data. Scanning Review of accounting data to identify significant or unusual items.

Reliability of Types of Evidence Table 5–6 General Guidelines for the Reliability Hierarchy by Evidence Type

Audit Testing Hierarchy Figure 5–3 Audit Testing Hierarchy: An Evidence Decision Process for Testing Significant Balances or Classes of Transactions

Filling the Assurance Bucket Figure 5–4 Filling the Assurance Bucket

Example of Filling the Assurance Buckets for Each Assertion (Accounts Payable) Figure 5–5 Accounts Payable Example of Filling the Assurance Buckets for Each Assertion

Audit Documentation The auditor’s record of the audit procedures performed, evidence obtained and conclusions reached. Audit documentation (working papers) has three functions: 1 To provide support for the audit report. 2 To aid in the planning, performance and supervision of the audit. 3 To provide basis for quality reviews; to provide evidence supporting the auditor’s significant conclusions.

Content of Audit Documentation Audit documentation provides the principal support for the representations in the auditor’s report and should: Demonstrate that the underlying accounting records agreed or reconciled with the financial statements. Support the basis for the auditor’s conclusions concerning each material financial statement assertion. Demonstrate how the audit complied with auditing and related professional practice standards.

Content of Audit Documentation Audit documentation should: Include a audit plan detailing auditing procedures necessary to accomplish audit objectives. Enable an experienced auditor to understand: The nature, timing and extent of audit procedures performed Significant matters arising during the audit, the conclusions reached thereon, and significant professional judgements made in reaching those conclusions The results of the audit procedures performed

Content of Audit Documentation Most public accounting firms maintain audit documentation in two types of files: Permanent files Current files Corporate charter Important contracts Chart of accounts Internal control documentation Organization chart Terms of stock and bond issues Prior years’ analytical procedures

Content of Audit Documentation Most public accounting firms maintain audit documentation in two types of files: Permanent files Current files Audit report Adjusting journal entries Audit strategy and plan Reclassification journal entries Working trial balance Current financial statements Minutes of meetings Working papers supporting accounts

Format of Audit Documentation Heading Entity name Title of the working paper Entity’s year-end date Indexing and cross-referencing Notations that provide a trail from financial statements to audit documents. Tick marks Notations made next to work paper items indicating auditor/reviewer actions.

Audit Documentation Audit documentation should be organized so that audit team members and others can find evidence supporting financial statement accounts. All audit documentation is the property of the auditor, including documents prepared by the entity at the auditor’s request. ISQC1 requires audit documentation to be retained ordinarily for minimum five years from the date of the auditor’s report.

Purposes of Analytical Procedures Risk Assessment Procedures Used to assist the auditor to better understand the business and to plan the nature, timing and extent of audit procedures. Substantive Analytical Procedures Used to obtain evidential matter about particular assertions related to account balances or classes of transactions. Final Analytical Procedures Used as an overall review of the financial information in the final review stage of the audit.

Purposes of Analytical Procedures (see Table 5-10) Trend Analysis Ratio Analysis Reasonableness Analysis

Substantive Analytical Procedures Decision Process Figure 5–7 Overview of the Auditor’s Decision Process for Substantive Analytical Procedures

Develop an Expectation Auditing standards require the auditor to have an expectation whenever analytical procedures are used. An expectation can be developed using a variety of information sources such as: Financial and operating data. Budgets and forecasts. Industry publications. Competitor information. Management’s analyses. Analyst’s reports.

Define a Tolerable Difference The size of the tolerable difference depends on: The significance of the account. The desired degree of reliance on the substantive analytical procedures. The level of disaggregation in the amount being tested. The precision of the expectation. But the amount should generally not exceed performance materiality!

Compare and Investigate Compare the expectation to the recorded amount and investigate any differences greater than the tolerable difference.

The Investigation of Differences for Risk Assessment and Final Analytical Procedures Risk Assessment Procedures Differences Final Analytical Procedures Differences Corroborating evidence is not required Corroborating evidence is required

Short-Term Liquidity Ratios Current Ratio Quick Ratio Operating Cash Flow Ratio

Days Outstanding in Accounts Receivable Days of Inventory on Hand Activity Ratios Receivables Turnover Days Outstanding in Accounts Receivable Inventory Turnover Days of Inventory on Hand

Gross Profit Percentage Profitability Ratios Gross Profit Percentage Profit Margin Return on Assets Return on Equity

Coverage Ratios Debt to Equity Times Interest Earned