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Audit Evidence:

A Framework

Rittenberg/Schwieger/JohnstoneAuditing: A Business Risk Approach

Sixth Edition

Chapter 5

Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

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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

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Overview (continued)

The evidence gathering process is the core of the audit; evidence is needed toReduce audit riskSupport the opinion

In deciding which evidence to gather, the auditor considersRisk associated with an account balance or

other measures of performanceTypes of evidence availableReliability of alternative sources of evidence

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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

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What is the assertion model?

The auditor gathers evidence to evaluate the management assertions embodied in the financial statements and individual accounts

Existence or occurrenceCompletenessRights and obligationsValuation or allocationPresentation and disclosure

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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

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The Steps in the OverallAudit Process

1. Understand the client and industry

2. Assess environment risk

3. Directly test transactions and/or account balances

4. Assess adequacy of evidence

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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

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Internal Documentation

Reliability varies withQuality 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

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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

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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

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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

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The Nature of Audit Testing (continued)

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

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The Nature of Audit Testing (continued)

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 balanceReliance forms of evidence are often

available

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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 analysisUnderstand and test systemTest account balances or other business

measurements

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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

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Audit Procedures: Understand and Test the System

For all systems:Inquire of management and employeesReview system documentationObserve system in operationDocument system flow and control pointsSelect transactions and trace through processing

Additional work for computerized systems:Test important computer controlsUse computer software to trace transactions through

systemUse software to select transactions for further

verification

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Audit Procedures: Test Account Balances or Other Business

Measurements

Direct tests of account balances:Review authoritative records and documentsExamine client-retained documentationExamine outside documentationExamine electronic records

Testimonial evidence:Inquire of client personnelInquire of and analyze responses from

outside parties

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Auditor-generated evidence:Direct observationPerform re-computationsReprocess transactions from source documents to

accounting recordsVouch transactions from accounting records back to

source documentsPhysically examine assetsPerform 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

Audit Procedures: Test Account Balances or Other Business

Measurements (continued)

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Directional Testing (Audit Efficiency)

Directional testing: auditor tests for over- or understatement, not both Increases audit efficiencyMisstatements 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)

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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

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Evidence-gathering Procedures (continued)

Observation of client personnel and proceduresMost often used to gain an understanding of

client processing systemAlso used to observe counting of physical

inventoryLimitations:

Intrusive and time-consumingEmployees know they're being watched and act

differently; this makes it difficult to generalize the evidence obtained

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Evidence-gathering Procedures (continued)

Physical examination of assetsUseful 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)

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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 evidenceConfirmations 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 fashionRespondents may not challenge figures in their favor

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Examination of documents Much of the audit process involves examining

documentsUseful for evaluating all of the assertionsAuditor should establish document

authenticity in order to rely on it

Recalculation Includes footing, cross-footing, tests of

extensions, re-computationOften used to test accuracy of estimated

accounts and allowances

Evidence-gathering Procedures (continued)

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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)

Evidence-gathering Procedures (continued)

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Vouching Reverse of reprocessingSelect sample of already recorded transactions and

trace back to the underlying source documentsHelps establish that recorded transactions are valid

(existence)

Analytics Compare recorded account balances (or ratios of

balances) to expectations developed by the auditorSources used to develop these expectations include

client's prior period information, industry data, expected results

Evidence-gathering Procedures (continued)

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Timing of Audit Procedures

In addition to what procedures to perform, the auditor must also decide when to perform themAs of the balance sheet dateAfter the balance sheet dateBefore the balance sheet date (interim testing)

Advantages of interim testing:Audit may be completed, and statements

distributed, soonerTypically means less overtime for audit staff

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Disadvantages of interim testing:Risk of material misstatement between

interim date and year-end

Interim testing is feasible:When client has strong internal controlsWhen 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)

Timing of Audit Procedures (continued)

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The 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

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What are audit programs? (1)

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 workMonitoring the audit processRecording audit work performedReviewing the audit procedures performed

and evidence gathered

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What is documenting audit evidence?

The audit work papers include all forms of documentation including:Evidence of planning, including audit programsThe client's trial balance and any auditor adjustmentsCopies of selected internal and external documents

including confirmation and representation letters and abstracts of company documents

Schedules prepared or obtained by the auditorAuditor memosResults of analytical procedures and tests of client

recordsAuditor analysis of account balance

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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

What are audit programs? (2)

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Characteristics of Good Audit Documentation

Well-developed audit documentation contains:A heading that includes client name, explanatory title,

and balance sheet dateInitials of the auditor who prepared the documentation

and date completedInitials of the reviewer and date review completedDescription of the tests performed and the findingsAssessment of whether tests indicate material

misstatement in an accountTick marks and legend indicating work performed by

the auditorIndex to identify the location of papersCross-reference to related documentation, when

applicable

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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