Chap 005
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Transcript of Chap 005
Audit Evidence and Documentation
Chapter 5
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
5-2
Audit RiskAudit Risk
The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated
This is the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP.
Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.
5-3
Financial Statement AssertionsFinancial Statement Assertions
Assertions about account balances (Accounts)
Assertions about classes of transactions and events (Transactions)
Assertions about presentation and disclosure (Disclosures)
5-4
Financial Statement Assertions: Auditing Financial Statement Assertions: Auditing
Standards Board and International StandardsStandards Board and International Standards Accounts Transactions Disclosures
Existence Occurrence Occurrence
Rights and obligations
Rights and obligations
Completeness Completeness Completeness
Valuation and allocation
Accuracy Accuracy and valuation
Cutoff
Classification Classification and understandability
5-5
Combined Assertions Combined Assertions Used in this TextUsed in this Text
Existence or Occurrence--Assets, liabilities, and equity interests exist and recorded transactions have occurred
Rights and Obligations--The company holds rights to the assets, and liability are the obligations of the company
Completeness--All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded
Cutoff—Transactions and events have been recorded in the correct accounting period
Valuation, Allocation and Accuracy—All transactions, assets, liabilities and equity interests are included in the financial statements at proper amounts
Presentation and Disclosure--Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressed
5-6
Audit RiskAudit Risk
Risk of Material Risk That the Audit Risk = Misstatement * Auditors Fail to the Misstatement
= Inherent Control Detection Risk * Risk * Risk
Inherent Risk--Risk of a material misstatement occurring in an assertion assuming no related internal controls.
Control Risk--Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control.
Detection Risk--Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.
5-7
Audit Risk FormulaAudit Risk Formula
AR = IR * CR * DR
AR = Audit riskIR = Inherent riskCR = Control riskDR = Detection risk
5-9
Inherent RiskInherent Risk
Factors that affect inherent risk: Nature of the client and its environment Nature of the particular financial statement element
Business characteristics indicative of high inherent risk: Inconsistent profitability of client Operating results highly sensitive to economic factors Going concern problems Large known and likely misstatements detected in prior audits Substantial turnover, questionable reputation, or inadequate
accounting skills of management
5-10
Assertions with high Assertions with high inherent riskinherent risk
Involve: Difficult to audit transactions or balances Complex calculations Difficult accounting issues Significant judgment by management Valuations that vary significantly based on
economic factors
5-11
Types of transactionsTypes of transactions
Routine Recurring financial statement activities recorded in the
accounting records in the normal course of business Lower inherent risk
Nonroutine Involve activities that occur only periodically such as the taking
of physical inventories High inherent risk
Estimation transactions Activities that create accounting estimates Higher inherent risk
5-12
The Third Field Work StandardThe Third Field Work Standard
Third standard of field work: The auditor must obtain sufficient appropriate audit
evidence by performing audit procedures to perform a reasonable basis for an opinion regarding the financial statements under audit
Sufficient audit evidence The quantity of audit evidence that must be obtained
5-13
Appropriateness of Audit Appropriateness of Audit EvidenceEvidence
To be appropriate audit evidence must be: Relevant Reliable
Principles—Audit evidence is ordinarily more reliable when it is
Obtained from knowledgeable independent sources outside the company rather than nonindependent sources
Generated internally through a system of effective controls rather than ineffective controls.
Obtained directly by the auditor rather than indirectly or by inference
Documentary in form rather than oral Provided by original documents rather than copies
5-14
Reliability of Certain Types of Reliability of Certain Types of Audit EvidenceAudit Evidence
RELIABILITY TYPE EXAMPLEHigh Physical Inventory Observation
DocumentaryExternal Cutoff Bank StatementExternal/Internal Purchase InvoiceInternal Sales Invoice
Low Client Representations Management Representation Letter
5-15
Types of Audit EvidenceTypes of Audit Evidence
Type Example
Accounting Information System The accounting records and support for transactions and journal entries
Documentary evidence Checks, invoices, contracts, minutes of meetings.
Third-party representations Confirmations, lawyer’s letters, specialist’s reports
Physical evidence Examination of asset
Computations Footing, recalculations
Data interrelationships Analytical procedures
Client representations Representation letter
5-16
Overall Types of Audit Procedures Overall Types of Audit Procedures
Risk assessment procedures To obtain an understanding of the client and its
environment, including its internal control, to assess the risks of material misstatement
Further Audit Procedures Tests of controls
When appropriate, to test the operating effectiveness of controls in preventing material misstatements
Substantive procedures To detect material misstatements at relevant assertion level.
Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosures
5-17
Substantive ProceduresSubstantive Procedures Analytical procedures Tests of details
• Tests of account balances• Tests of classes of transactions• Tests of disclosures
One may change the scope of audit procedures by changing the (NTE, or re-ordered as NET):
• Nature (type and form)• Timing (when performed)• Extent (quantity of evidence obtained)
5-18
Nature and Timing of Procedures Nature and Timing of Procedures
Holding the extent of procedures constant, one may increase the scope of procedures (make them more effective) by either changing the
Nature-- obtain more reliable evidence• often externally generated evidence.
Timing--wait until year-end to obtain evidence from entire set of transactions as contrasted to performing interim testing, say two months prior to year-end and simply updating those procedures.
5-19
Extent of ProceduresExtent of Procedures
Holding other factors such as the nature and timing of procedures constant: The greater the risk of material misstatement,
the greater the needed extent of substantive procedures
The main way to increase the extent of audit procedures is to examine more items
Sample sizes should reduce detection risk so as to restrict audit risk to a low level
5-20
Analytical Procedures (1 of 2)Analytical Procedures (1 of 2) Steps involved
Develop expectation of account (or ratio) balance Determine amount of difference that can be accepted without
investigation Compare the company’s account (ratio) with the expectation Investigate and evaluate significant differences
Developing an expectation Prior period information Anticipated results Relationships among elements of financial information within a
period Industry information Relationships between financial information and relevant
nonfinancial data.
5-21
Analytical Procedures (2 of 2) Analytical Procedures (2 of 2)
Types of Expectations Trend analysis—analyze changes in accounts of a
company over time Ratio analysis – compare relationships between two
or more financial statement accounts or comparisons of account balances to nonfinancial data
• Liquidity (e.g., current ratio)• Leverage (e.g., debt to equity)• Profitability (e.g., gross profit percentage)• Activity (e.g., inventory turnover)
5-22
Ratio Analysis Ratio Analysis Approaches to ratio analysis
Horizontal analysis• Review ratios over time
Cross sectional analysis• Analyze ratios of similar firms at a point in time
Vertical analysis• Analyze relationships within a period
• “Common size” statements prepared Other methods
• Regression analysis, reasonableness test
5-24
Basic Approaches to Auditing Basic Approaches to Auditing Accounting EstimatesAccounting Estimates
Review and test management’s process for developing the estimate.
Independently develop an estimate to compare to management’s estimate.
Review subsequent events or transactions bearing on the estimate.
5-25
Auditing Fair ValuesAuditing Fair Values Inputs to use in applying valuation techniques (FAS
157) Level 1 – inputs of observable quoted prices in
active markets for identical assets or liabilities• Ex. A closing stock price in WSJ
Level 2 – inputs of observable quoted prices, generally for similar assets or liabilities in active markets
• Ex. Company discounts future cash flows on its not publicly traded debt securities at rate used by market for publicly traded debt securities
Level 3 – inputs that are unobservable for the assets or liability
• Ex. A private company uses judgment to determine a proper rate to discount the future cash flows of its not publicly traded securities
5-26
Related Party TransactionsRelated Party Transactions
Disclosure requirements must be met Primary challenge is identifying
undisclosed related party transactions Determine related parties
• Inquiries of management• Review SEC filings, stockholder’s listings and
conflict-of-interest statements Be alert for transactions with related parties
and any transactions with unusual terms
5-27
Functions of Audit DocumentationFunctions of Audit Documentation
Primary functions:•Support the auditors’ compliance with auditing standards•Support the auditors’ opinion
Secondary functions:•Assist continuing and new audit team members in planning and performing the audit
•Serves as a record of matters of continuing audit interest•Assists in supervision and review of the audit•Demonstrates the accountability of team members•Assists internal reviewers, external peer reviewers, PCAOB inspectors, and successor auditors in performing their roles
5-28
Sufficiency of Audit DocumentationSufficiency of Audit Documentation
Audit documentation should be sufficient to: Enable an experienced auditor to understand the
work performed and the significant conclusions reached
Identify who performed and reviewed the work Show that the accounting agree or reconcile to the
financial statements Audit documentation should include all
significant audit findings and the actions taken to address them
5-29
Types of Working PapersTypes of Working Papers
Audit administrative working papers Working trial balance Lead schedules Adjusting journal entries and reclassification
entries Supporting schedules Analysis of a ledger account Reconciliations Computational working papers Corroborating documents
5-30
Types of Working FilesTypes of Working Files
Current files Current year working papers Index and cross-referencing
Permanent files Items of continuing audit
interest