[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide 10.1 Substantive Testing and Evidence Principles of Auditing: An Introduction to International Standards on Auditing - Ch. 10 Rick Stephan Hayes, Roger Dassen, Arnold Schilder, Philip Wallage

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide 10.2 Evidence Evidence is anything that can make a person believe that a fact, proposition, or assertion is true or false. Audit evidence is all of the information used by the auditor in arriving at the conclusions on which the audit opinion is based. (ISA 500) –It includes the accounting records and other information underlying the financial statements.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide 10.3 Audit evidence is different from the legal evidence.  In a civil lawsuit, evidence must be strong enough to incline a person to believe one side or the other.  In a criminal case evidence must establish proof of a crime beyond a reasonable doubt.  Audit evidence provides only reasonable assurance

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide 10.4 Accounting records generally include the records of initial entries and supporting records. Initial entries include: records of initial entries such as checks and electronic fund transfers; contracts, invoices; shipping notices, purchase orders, sales orders, the general and subsidiary ledgers, journal entries and other adjustments to the financial statements. Supporting records examples are computer files, databases, work sheets, spreadsheets, computer and manual logs, computations, reconciliations, and disclosures. evidence

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide 10.5 The auditor obtains audit evidence to draw reasonable conclusions on which to base the audit opinion by performing audit procedures to: Obtain an understanding of the entity and its environment, including its internal control, to assess the risks of material misstatement at the financial statement and assertion levels (“risk assessment procedures”); Test the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level (“tests of controls”); and Detect material misstatements at the assertion level (“substantive procedures”) – ISA 500

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide 10.6 Substantive Procedures Defined Substantive procedures are tests performed to obtain audit evidence to detect material misstatements at the assertion level. Two types – (1) tests of details of classes of transactions, account balances, and disclosures and (2) substantive analytical procedures

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide 10.7

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide 10.8 Legal Proof and Evidence Legal standards of proof – beyond a reasonable doubt – preponderance of evidence – clear and convincing evidence – probable cause Legal evidence – proof results direct or circumstantial – Source real tangible and can be presented to a court for inspection testimonial evidence given by witnesses under oath. original documentary evidence

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide 10.9 ASSERTIONS about classes of transactions and events for the period under audit OccurrenceTransactions and events that have been recorded have occurred and pertain to the entity. CompletenessAll transactions and events that should have been recorded have been recorded. AccuracyAmounts and other data relating to recorded transactions and events have been recorded accurately. CutoffTransactions and events have been recorded in the correct accounting period ClassificationTransactions and events have been recorded in the proper accounts Illustration 10.2

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide ASSERTIONS about account balances at the period end ExistenceAssets, liabilities, and equity interests exist Rights and obligationsThe entity holds or controls the rights to assets and liabilities are the obligations of the entity CompletenessAll assets, liabilities and equity interests that should have been recorded have been recorded Valuation and Allocation Assets, liabilities and equity interests are included in the financial statements at appropriate amounts and any resulting valuation adjustments are appropriately recorded Illustration 10.2

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide ASSERTIONS about presentation and disclosure Occurrence and rights and obligations Disclosed matters have occurred and pertain to the entity. CompletenessAll disclosures that should have been included in the financial statements have been included Classification and understandability (not in text) financial information is appropriately presented and described, and disclosures are clearly expressed Accuracy and valuation Financial and other information are disclosed fairly and at appropriate amounts Illustration 10.2

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Sufficiency is the measure of the quantity of audit evidence Appropriateness is the measure of quality of audit evidence, its reliability, & its relevance in providing support for, or detecting, misstatements in transactions, balances, disclosures and related assertions Sufficient Appropriate Audit Evidence

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Relevance of evidence is the appropriateness (pertinence) of the evidence to the audit objective being tested. Reliability is the quality of information when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide 10.14

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide  Audit evidence obtained directly by the auditor (e.g., observation, re-performance) is more reliable than audit evidence obtained indirectly or by inference.  Audit evidence is more reliable when it exists in documentary form, whether paper, electronic, or other medium.  Audit evidence is more reliable when it is obtained from independent sources outside the entity..  Audit evidence provided by original documents is more reliable than audit evidence provided by photocopies or facsimiles.  The effectiveness of the client’s internal control structure has a significant impact on reliability of evidence. Reliability of audit evidence

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Information Provided by the Auditee When information produced by the entity is used by the auditor to perform audit procedures, the auditor should obtain audit evidence about the accuracy and completeness of the information.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Nature of Substantive procedures  Tests of details of transactions are audit procedures related to examining the processing of particular classes of transactions through the accounting systems.  Tests of balances are substantive tests that provide either reasonable assurance of the validity of a general ledger balance or identifies a misstatement in the account.  Analytical procedures

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Tests of Balances  Tests of Balances are used to examine the actual details making up high turnover accounts such as cash, Accounts Receivable, Accounts Payable, etc.. Why is tests of balances so important?  Because the auditor’s ultimate objective is to express an opinion on financial statements that are made up of account balances.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Tests of Balances In tests of balances the auditor is concerned with overstatement or understatement of the line item in the financial statement.  Test makes use of the inherent properties of double-entry accounting systems.  From the auditor’s perspective, this means that a test of one side of the transaction simultaneously tests the other side of the transactions.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Audit Procedures for Gathering Evidence Evidence-gathering techniques are techniques employed by an auditor to obtain evidence. Evidence-gathering techniques are: –I nquiry –O bservation –I nspection (physical evidence and examination of documents) –Recalculation –Reperformance –C onfirmation –A nalytical procedures. –

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Inquiry consists of seeking information of knowledgeable persons inside (client) or outside the entity. Largest amount of audit evidence in an audit is obtained from client inquiry cannot be regarded as conclusive because it is not from an independent source and might be biased the auditor must gather evidence to corroborate inquiry evidence by doing other alternative procedures. Inquiry

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Famous court case of Escott et al. vs. Bar Chris Corp. 1968, wherein the court ruled against the auditor because he did not seek supporting evidence related to inquiries made with management. The court stated he was, “too easily satisfied with glib answers to his inquiries.” Inquiry

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Observation  Observation consists of looking at a process or procedure being performed by others.  For example, the observation by the auditor of the counting of inventories by the entity’s personnel or by the performance of internal control procedures that leave no audit trail.  Observation should be supported by other types of evidence.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide count of physical inventory ISA 501 “When inventory is material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding its existence and condition by attendance at physical inventory counting.” If unable to attend the physical inventory count, the auditor should take or observe some physical counts on an alternative date and, when necessary, perform tests of controls of intervening transactions.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Alternative procedures for attending physical inventory include Auditor review of: Management’s instructions regarding the application of control procedures (e.g. collection of used stock sheets, accounting for unissued stock sheets and count and re-count procedures); Accurate identification of the stage of completion of work in progress, of slow-moving, obsolete, or damaged items and items on consignment Whether appropriate arrangements are made regarding the movement of inventory between areas and the shipping and receipt of inventory before and after the cutoff date.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Inspection Inspection is the auditor's examination of the client's documents records or tangible assets to substantiate the important information related to the financial statements.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Internal documents and external documents.  Internal documents processed under good internal controls are more reliable than those processed under weak controls.  External documents may be processed by both internal and external parties representing agreement.  External documents like title to property, insurance policies and contracts are very reliable evidence.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Vouching and Tracing  Vouching is the use of documentation to support recorded transactions or amounts. It is an audit process whereby the auditor selects sample items from an account and goes backward through the accounting system to find the source documentation that supports the item selected.  Tracing is an audit procedure whereby the auditor selects sample items from basic source documents and proceeds forward through the accounting system to find the final recording of the transactions (e.g., in the ledger).

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Recalculation & Reperformance Recalculation consists of checking the arithmetical accuracy of source documents and accounting records or of performing independent calculations. Reperformance is the auditor’s independent execution of procedures or controls that were originally performed as part of the entity’s internal control, either manually or through the use of CAATs.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Examples:  Extending sales invoices  Adding journals and subsidiary records  Checking calculations of depreciation  Checking mechanical accuracy of records and ledgers. Recalculation

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide CONFIRMATION Defined: It is the auditor’s receipt of a written or oral response from a independent third party verifying the accuracy or the information requested. Four Key Characteristics: 1. Information is requested by auditor. 2. Request and response is in writing, sent to the auditor. 3. Response comes from an independent third party. 4. Positive confirmation involves a receipt of information.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Confirmation  An auditor may use a confirmation in response to a significant risk  The auditor must ordinarily confirm accounts receivable. . Written confirmations received from third parties are highly persuasive, but very costly and an inconvenience for those who are asked to supply them.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide  Positive confirmation: Asks the recipient (debtor, creditor or other third party) to confirm agreement or to express disagreement with the recorded balance.  Reliable evidence  Negative confirmation: A reply is requested only in the event of disagreement with the recorded balance.  Use for large number small balances, low control risk, response is expected

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Search for unrecorded liabilities Defined:  A substantive test usually performed on accounts payable is a search for unrecorded liabilities.  This test provides evidence as a completeness and some evidence as to valuation.  By reviewing cash disbursements subsequent to the balance sheet date, the auditor has a good idea of the potential population of unrecorded accounts payable.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Reliability of Procedures most reliable least reliable A list of the most reliable to the least reliable evidence gathering techniques are in general: 1 Recalculation 2. Inspection. 3 Reperformance. 4 Observation. 5 Confirmation. 6 Analytical procedures. 7 Inquiry.

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide The auditor considers the relationship between the cost of obtaining audit evidence and the usefulness of the information obtained. The evidence-gathering procedures in order of cost from most costly to least costly are in general: 1 Confirmation. 2 Inspection. 3 Recalculation 4. Reperformance 5 Observation. 6 Analytical procedures. 7 Inquiry. Cost of Procedures

[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007 Slide Thank You for Your Attention Any Questions?