05 CH-5 Audting-2.ppt-class.ppt material

CHAPTER FIVE
AUDIT EVIDENCE, EVALUATION
AND DOCUMENTATION
1

The foundation of any audit is the evidence
obtained and evaluated by the auditor.
The auditor must have the knowledge and skill to
accumulate sufficient appropriate evidence on
every audit to meet the standards of the
profession.
2

Audit Evidence and Materiality
Audit Evidence and Materiality
Audit evidence: is any information used by the auditor
to determine whether the information being audited is
stated in accordance with the established criteria
Can be obtained via inspection/examination, observation,
inquiries, and confirmations.
3

Why Audit Evidence?
A professional requirement by field work standard
(sufficient appropriate evidences).
Auditor should identify sufficient, reliable/trustworthy,
relevant and useful information to provide factual
basis for audit opinions.
4

AUDIT EVIDENCE DECISIONS
There are four decisions about what evidence to gather and
how much of it to accumulate:
1. Which audit procedures to use.
2. What sample size to select for a given procedure.
3. Which items to select from the population.
4. When to perform the procedures.
5

1.
1. Which Audit Procedures to Use
Which Audit Procedures to Use
The detailed instruction that explains the audit evidence
to be obtained during the audit.
Example: The following is an audit procedure for
the verification of cash disbursements: Examine the
cash disbursements journal in the accounting system and compare the
payee, name, amount, and date with online information provided by the
bank about checks processed for the account.
6

2. What Sample Size to Select for A Given Procedure
 Auditors can vary the sample size from one to all the
items in the population being tested.
 Suppose 6,600 checks are recorded in the cash
disbursements journal, the auditor might select a sample
size of 50 checks
7

3. Which items to select from the population.
 The auditor must decide which items in the population to
test:
 The selection might be from largest checks
 Select the checks randomly
 Select those checks that the auditor thinks are
most likely to be in error.
8

4. When to perform the procedures (timing)
An audit of financial statements usually
covers a period such as a year
The timing decision is affected by when the
client needs the audit to be completed.
9

AUDIT PROGRAM
10
The list of audit procedures for an audit area or
an entire audit is called an audit program
Most auditors use computers to facilitate
Most auditors use computers to facilitate
the preparation of audit programs.
the preparation of audit programs.
 Sample sizes
Sample sizes
 Items to select
Items to select
 Timing of the tests
Timing of the tests

Persuasiveness/EXPRESSIVENESS of Evidence
Audit standards require the auditor to accumulate
sufficient appropriate evidence to support the opinion
issued.
Because of the nature of audit evidence and the cost
considerations of doing an audit, it is unlikely that the
auditor will be completely influenced that the opinion is
correct.
11

However, the auditor must be persuaded that the opinion is
correct with a high level of assurance.
The two determinants of the persuasiveness of evidence are:
1. Competence and
2. Sufficiency.
12

1. COMPETENCE OF EVIDENCE:
• Competence of evidence refers to the degree to which evidence can
be considered believable or worthy of trust.
• If evidence is considered highly competent, it is a great help in
persuading the auditor that financial statements are fairly stated.
• For example, if an auditor counted the inventory, that evidence
would be more competent than if management gave the auditor its
own figure. In most cases, the term reliability of evidence is being
used synonymously with competence.
13

COMPETENCE OF EVIDENCE:
• Competence cannot be improved by selecting a larger
sample size or different population items.
• It can be improved only by selecting audit procedures that
contain a higher quality of one or more of the following
seven characteristics of the competent evidence:
Relevance, independence of provider, effectiveness of
client's internal control, auditor's direct knowledge,
qualification of individuals proving the information,
degree of objectivity, and timeliness.
14

A. Relevance of evidence
Evidence must pertain to or be relevant to the audit objective .
A relevant procedure is to trace a sample of shipping/delivery/ documents
to related duplicate sales invoices to determine whether each shipment was
billed/paid.
15

Factors Affecting Competence include
Factors Affecting Competence include:
:
Independence of provider
Independence of provider
 Effectiveness of internal controls .
Effectiveness of internal controls .
 Auditor’s direct knowledge
Auditor’s direct knowledge
 Qualifications of providers
Qualifications of providers
 Degree of objectivity
Degree of objectivity
 Timeliness
Timeliness
16

1. Independence of provider.
 Evidence obtained from a source outside the entity is more reliable
than that obtained from within organization.
 Communications from banks, attorneys, or customers is generally
considered more reliable than answers obtained from inquiries of the
client.
2. Effectiveness of client’s internal controls.
 When a client’s internal controls are effective, evidence obtained is
more reliable than when they are weak.
For example, if internal controls over sales and billing are effective, the auditor obtain
more reliable evidence from sales invoices and shipping documents than if the
controls were inadequate.
17

3. Auditor’s direct knowledge.
 Evidence obtained directly by the auditor through
physical examination, observation, recalculation, and
inspection is more reliable than information obtained
indirectly.
For example, if the auditor calculates the gross margin as
a percentage of sales and compares it with previous
periods, the evidence is more reliable than if the auditor
relies on the calculations of the controller. 18

4. Qualifications of individuals providing the
information.
Although the source of information is independent,
the evidence will not be reliable unless the individual
providing it is qualified to do so.
Therefore, communications from attorneys & bank
confirmations are more highly regarded than A/R
confirmations for example from persons not familiar
with the business world.
19

Also, evidence obtained directly by the
auditor may not be reliable if the auditor
lacks the qualifications to evaluate the
evidence.
For example, examining an inventory of
diamonds by an auditor not trained to
distinguish between diamonds and glass is
not reliable evidence for the existence of
diamonds.
20

5. Degree of objectivity.
Objective evidence is more reliable than evidence
that requires considerable judgment to determine
whether it is correct.
Examples of objective evidence include:
Confirmation of A/R and bank balances, the physical
count of securities and cash, and adding (footing) a list
of A/P to determine whether it agrees with the balance in
the general ledger. 21

6. Timeliness.
The timeliness of audit evidence refer either to when it is
accumulated or to the period covered by the audit.
Evidence is usually more reliable for balance sheet accounts
when it is obtained as close to the balance sheet date as
possible.
E.g. The auditor’s count of marketable securities on the balance
sheet date is more reliable than a count 2 months earlier.
For Income Statement accounts, evidence is more reliable if
there is a sample from the entire period under audit.
22

2. Sufficiency of Evidence
Measured by the quantity of evidence obtained in terms of sample
size.
For a given audit procedure, the evidence obtained from a sample of
100 is ordinarily more sufficient than from a sample of 50.
Several factors determine the appropriate sample size in audits.
The two most important ones are the
1. Auditor’s expectation of misstatements and
2. The effectiveness of the client’s internal controls. 23

To illustrate, assume in the audit of Jones Computer Parts Co.
that the auditor concludes that there is a high likelihood of
obsolete inventory because of the nature of the client’s industry.
Thus, the auditor will sample more inventory items for
obsolescence inventory.
Similarly, if the auditor concludes that a client has effective
rather than ineffective internal controls over recording fixed
assets, a smaller sample size in the audit of acquisitions of
fixed assets under taken.
24

3. Combined effect
The persuasiveness of evidence can be evaluated only after
considering the combination of appropriateness and sufficiency,
including the effects of the factors influencing appropriateness and
sufficiency.
A large sample of evidence provided by an independent party is not
persuasive unless it is relevant to the audit objective being tested.
A large sample of evidence that is relevant but not objective is also
not persuasive.
Similarly, a small sample of only one or two pieces of highly
appropriate evidence also typically lacks persuasiveness.
25

3.4. Audit Risk and its components
Audit risk , the risk that an auditor may give inappropriate audit opinion
on financial statements .e.g. an unqualified audit opinion on financial
statements that are materially misstated.
Risk in auditing means, the auditor accepts some level of uncertainty in
performing the audit function:
Uncertainty:
- About the competence of evidence,
- About the effectiveness of a client's internal control structure and,
In the end, as to whether the financial statements are fairly stated. 26

Audit Risk Model is presented as:
Risk of Material Risk that the Auditors
Audit Risk = Misstatement X Fail to Detect
the Misstatement
= Inherent Control Detection
Risk X Risk X Risk
27

PDR = AAR / (IR x CR)
This model illustrates, how the amount of substantive
testing has to perform (which is a function of PDR =
Planned Detection Risk), depends on:
AAR ( Acceptable Audit Risk),
IR (Inherent Risk),
CR (Control Risk). 28

1. Inherent Risk
1. Inherent Risk
Is measure of the sensitivity or susceptibility of the Financial
statement accounts to material misstatement before
considering the effectiveness of internal control, accounting
controls, policies or procedures.
Related to:
Nature of the client or industry
Nature of the financial statement account.
29

2. Control Risk
CR measures auditor’s assessment of whether
misstatement exceeding a tolerable amount in a
segment will be prevented or detected on a timely
basis by the client’s internal controls.
Auditor concludes that internal controls are
completely ineffective to prevent or detect
misstatements.
30

3. Planned Detection Risk
DR is the risk that the auditor will fail to detect the material
misstatement with their audit procedure.
There key points to know about PDR
The nature of substantive procedures;
The timing of substantive procedures; or
The extent of substantive procedures.
31

5.5. TYPES OF AUDIT EVIDENCE
32
1.
1. Physical examination(tangible assets)
Physical examination(tangible assets)
2.
2. Confirmation (+ve and -ve)
Confirmation (+ve and -ve)
3.
3. Documentation
Documentation
4.
4. Analytical procedures
Analytical procedures
5.
5. Inquiries of the client
Inquiries of the client
6.
6. Re - calculation
Re - calculation
7.
7. Re - performance
Re - performance
8.
8. Observation
Observation

1. Physical Evidence (tangible assets)
Is the inspection or count by the auditor of a tangible
asset.
This type of evidence is most often associated with
inventory and cash, but it is also applicable to the
verification of securities, N/R, and tangible fixed assets.
33

Physical examination is:
A direct means of verifying that an asset actually exists
(existence objective), and
To a lesser extent whether existing assets are recorded
(completeness objective).
It is considered as one of the most reliable and useful types of audit
evidence.
Generally, physical examination is an objective means of :
Ascertaining both the quantity and the description of the asset.
34

2. Confirmation (Positive And Negative)
The receipt of a direct written response from a third party: For verifying the
accuracy of information.
The response either in electronic or paper form.
The request is made to the client, & the client asks the third party to
respond directly to the auditor.
Confirmation are a highly regarded and often-used type of evidence.
However, confirmations are relatively costly to obtain and cause some
inconvenience to those asked to supply them.
Therefore, they are not used in every instance in which they are
applicable. 35

Confirmations and Information Often Confirmed
36
Assets
Assets
Cash in bank (example)
Cash in bank (example) Bank
Bank
Accounts receivable
Accounts receivable Customer
Customer
Notes receivable
Notes receivable Maker
Maker
Owned inventory out on consignment
Owned inventory out on consignment Consignee
Consignee
Inventory held in public warehouses
Inventory held in public warehouses Warehouse
Warehouse
Cash surrender value of life insurance
Cash surrender value of life insurance Insurance co.
Insurance co.
Information
Information Source
Source
Confirmations may be positive or negative.
Confirmations may be positive or negative.

Information Often Confirmed
37
Liabilities
Liabilities
Accounts payable
Accounts payable Creditor
Creditor
Notes payable
Notes payable Lender
Lender
Advances from customers
Advances from customers Customer
Customer
Mortgages payable
Mortgages payable Mortgagor
Mortgagor
Bonds payable
Bonds payable Bondholder
Bondholder
Information
Information Source
Source

Information Often Confirmed
38
Owners’ Equity
Owners’ Equity
Shares outstanding
Shares outstanding Registrar and
Registrar and
transfer agent
transfer agent
Other Information
Other Information
Insurance coverage
Insurance coverage Insurance co.
Insurance co.
Contingent liabilities
Contingent liabilities Bank, lender,
Bank, lender,
and clients
and clients
legal counsel
legal counsel
Bond indenture agreements
Bond indenture agreements Bondholder
Bondholder
Collateral held by creditors
Collateral held by creditors Creditor
Creditor
Information
Information Source
Source

3. Documentation
Is the auditor’s inspection of the client’s documents and records to
substantiate the information that is, included in the Financial
statement Usually available at a relatively low cost.
Sometimes, it is the only reasonable type of evidence available.
E.g. The client often retains a customer order, a shipping document,
and a duplicate sales invoice for each sales transaction.
Documentation can be an internal and external
39

An internal document prepared and used within the client’s
organization and is retained without ever going to an outside
party.
It Includes duplicate sales invoices, employees’ time reports, &
inventory receiving reports.
An external document handled by someone outside the client’s
organization .
In some cases, external documents originate outside the
client’s organization and end up in the hands of the client.
E.g. vendors’ invoices, cancelled notes payable, and insurance
policies. 40

4. Analytical Procedures
Used for comparisons and relationships
To assess whether account balances or other data appear reasonable
compared to the auditor’s expectations.
E.g. an auditor may compare the gross margin percent in the current year with the
preceding year’s.
It used extensively in practice, and
Are required during the planning and completion phases on all audits 41

Analytical procedures are used for:
Understand the Client’s Industry and Business
Assess the entity’s ability to continue as a going concern
Indicate the presence of possible misstatements in the financial
statements.
Reduce detailed audit tests
42

5. Inquiries of the Client
Is the obtaining of written or oral information from the client in
response to questions from the auditor.
It usually cannot be regarded as conclusive because it is not
from an independent source and may be biased in the client’s
favor.
Therefore, when the auditor obtains evidence through inquiry, it is
necessary to obtain corroborating evidence through other
procedures (Corroborating evidence is additional evidence to
support the original evidence.)
43

6. Re- calculation
Involves rechecking a sample of calculations made by the client.
Rechecking client calculations consists of testing the client’s arithmetical
accuracy.
A considerable portion of auditors’ recalculation is done by computer-
assisted audit software.
7. Re- performance
Is the auditor’s tests of accounting procedures or controls that were
originally done as part of the entity’s accounting and internal control
system.
recalculation involves rechecking a computation, but re-performance
involves checking other procedures. 44

8. Observation
Is the use of the senses to assess client activities.
Auditors have many opportunities to use their
senses-sight, hearing, touch, and smell-to evaluate a
wide range of items.
45

5.6. Audit Documentation
46
Is the principal record of auditing procedures
Is the principal record of auditing procedures
applied, evidence obtained, and conclusions
applied, evidence obtained, and conclusions
reached by the auditor in the engagement.
reached by the auditor in the engagement.
AD include all the information that the auditor considers
necessary .
It also be referred to as working papers, although AD is often
maintained in computerized files.

Purposes of audit documentation
Purposes of audit documentation
a.
a.A base for planning the audit
A base for planning the audit
b.
b.A Record of the Evidence Accumulated and
A Record of the Evidence Accumulated and
the Results of the Tests
the Results of the Tests
C. Data for determining the proper type of audit Report
C. Data for determining the proper type of audit Report
D. A Basis for Review by Supervisors and Partners
D. A Basis for Review by Supervisors and Partners
Ownership of audit files – property of Auditor
Ownership of audit files – property of Auditor
Confidentiality of audit files – kept
– kept confidential
confidential.
.
Requirements for Retention of Audit Documentation –
not less than seven years 47

Permanent Files
48
These files are intended to contain data of a
These files are intended to contain data of a
historical or continuing
historical or continuing nature
nature pertinent to the
pertinent to the
current audit. Examples include:
current audit. Examples include:
 Articles of incorporation
Articles of incorporation
 Loan agreements
Loan agreements
 Documents related to understanding IC
Documents related to understanding IC

Current Files
49
Audit program required for every audit
Audit program required for every audit
General information e.g. planning memos,
General information e.g. planning memos,
abstract of
abstract of copies of minutes
copies of minutes
Working trial balance
Working trial balance
Adjusting and reclassification entries
Adjusting and reclassification entries
Supporting schedules
Supporting schedules

Types of Supporting Schedules
50
Analysis
Analysis
Trial balance or list
Trial balance or list
Reconciliation of amounts
Reconciliation of amounts
Tests of reasonableness
Tests of reasonableness
Summary of procedures
Summary of procedures
Examination of supporting documents
Examination of supporting documents
Informational
Informational
Outside documentation
Outside documentation

Characteristics of Audit Documentation
51
Each audit file should be properly identified.
Each audit file should be properly identified.
Documentation should be indexed and
Documentation should be indexed and
cross-referenced.
cross-referenced.
Completed documentation must clearly indicate
Completed documentation must clearly indicate
the audit work performed.
the audit work performed.
It should include sufficient information.
It should include sufficient information.
It should plainly state the conclusions reached.
It should plainly state the conclusions reached.

Thank u
End of chapter 5
End of course
52

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