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

1
Chapter 7

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

2
Overview

• Auditing 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

3
Overview (continued)

• The evidence gathering process is the core of the
  audit evidence is needed to
• Reduce audit risk
• Support the opinion
• In deciding which evidence to gather, the auditor
  considers
• Risk associated with an account balance or other
  measures of performance
• Types of evidence available
• Reliability of alternative sources of evidence

4
Define the Third Standard of Fieldwork

• Sufficient, 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

5
What is the assertion model?

• The auditor gathers evidence to evaluate the
  management assertions embodied in the financial
  statements and individual accounts
• Existence or occurrence
• Completeness
• Rights and obligations
• Valuation or allocation
• Presentation and disclosure

6
Review Gathering 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 integrity
• Client economic risk
• Quality of client's information system
• Client's control structure
• Current market conditions and competitor actions

7
List the Steps in the Overall Audit Process

• 1. Understand the client and industry
• 2. Assess environment risk
• 3. Directly test transactions and/or account
  balances
• 4. Assess adequacy of evidence

8
Discuss Sufficient, Competent Evidence

• 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
• 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

9
Comment on 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

10
Comment on 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

11
Discuss 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

12
What is the nature of audit testing?

• When 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

13
More Nature of Audit Testing

• 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

14
Even More Nature of Audit Testing

• 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 balance
• Reliance forms of evidence are often available

15
Discuss 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
• Understand and test system
• Test account balances or other business
  measurements

16
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

17
Audit Procedures Understand and Test 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

18
Audit Procedures Test Account Balances or Other
Business Measurements

• Direct tests of account balances
• Review authoritative records and documents
• Examine client-retained documentation
• Examine outside documentation
• Examine electronic records
• Testimonial evidence
• Inquire of client personnel
• Inquire of and analyze responses from outside
  parties

19
Audit Procedures Test Account Balances or Other
Business Measurements (continued)

• Auditor-generated evidence
• Direct observation
• Perform re-computations
• Reprocess transactions from source documents to
  accounting records
• Vouch transactions from accounting records back
  to source documents
• Physically examine assets
• Perform analytical 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

20
Discuss Directional Testing (Audit Efficiency)

• Directional testing auditor tests for over- or
  understatement, not both 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
  accounts
• Some management assertions are directional by
  nature (existence addresses overstatement
  completeness, understatement)

21
Discuss 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 those procedures
• The primary types of audit procedures include
• Observation of client personnel and procedures
• Physical examination of assets
• Inquiry
• Confirmations
• Examination of documents
• Re-computation of data
• Reprocessing transactions
• Vouching transactions
• Analytical procedures

22
Review Evidence-gathering Procedures

• Observation of client personnel and procedures
• Most often used to gain an understanding of
  client processing system
• Also used to observe counting of physical
  inventory
• Limitations
• Intrusive and time-consuming
• Employees know they're being watched and act
  differently this makes it difficult to
  generalize the evidence obtained

23
Review Evidence-gathering Procedures (continued)

• Physical examination of assets
• Useful in verifying existence of tangible assets
• May be useful in identifying potential
  obsolescence or wear and tear
• Does not provide evidence on completeness,
  ownership, or proper valuation (except as in item
  above)

24
Review Evidence-gathering Procedures (Continued)

• Inquiry
• Used extensively, especially early in the audit
  to gain an understanding
• Efficient way to gather evidence
• Not considered persuasive, should be corroborated
  by other sources of evidence
• 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

25
Review Evidence-gathering Procedures (Continued)

• Evidence-gathering Procedures (Continued)
• Examination of documents
• Much of the audit process involves examining
  documents
• Useful for evaluating all of the assertions
• Auditor should establish document authenticity in
  order to rely on it
• Recalculation
• Includes footing, cross-footing, tests of
  extensions, re-computation
• Often used to test accuracy of estimated accounts
  and allowances

26
Review Evidence-gathering Procedures (Continued)

• Test of transactions involve reconciling source
  documents with recorded accounting information
• Reprocessing
• 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)

27
Review Evidence-gathering Procedures (Continued)

• Vouching
• Reverse of reprocessing
• Select sample of already recorded transactions
  and trace back to the underlying source documents
• Helps establish that recorded transactions are
  valid (existence)
• 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

28
Comment on 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

29
Comment on Timing of Audit Procedures (continued)

• 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)

30
Discuss Extent of Audit Procedures

• In 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

31
What are 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 work
• Monitoring the audit process
• Recording audit work performed
• Reviewing the audit procedures performed and
  evidence gathered

32
What is documenting audit evidence?

• The 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

33
What are audit programs?

• 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

34
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

35
Importance of 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