AUDITING CHAPTER 6

Evidence By David N. Ricchiute

TOPICS
Acquisition & evaluation of evidence Financial statement assertions, audit objectives, & audit procedures Tests of controls, substantive tests, analytical procedures & nonfinancial measures Audit documentation

GBW 8th ed., Ch. 6

AUDIT EVIDENCE
Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding financial statements under audit.
SAS 31 & SAS 80, Amendment to SAS 31.
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MEANING OF SUFFICIENT, COMPETENT EVIDENCE

Sufficient: quantity of evident necessary to test managements assertions Competent: relevant, valid, reliable

Kinds of evidence necessary to test managements assertions

Relevance Amount of evidence
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Link audit risk & audit evidence

EVIDENTIAL MATTER
Underlying accounting data

Records of original entry (journals, ledgers, etc.) Data files Spreadsheets

Documents (checks, invoices, contracts) Written representations from 3rd parties (vendors, attorneys) Inquiries of management
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Corroborating information

FINANCIAL STATEMENT ASSERTIONS

Existence or Occurrence Completeness Rights & Obligations Valuation or Allocation Presentation & Disclosure
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ACCOUNTS & JOURNAL ENTRIES

Purchase & sale of inventory
Inventory Accounts payable Cost of Goods Sold Inventory

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EXISTENCE OR OCCURRENCE ASSERTION

All assets, liabilities, equities exist All transactions occurred Example

Test whether inventory physically existed at balance sheet date

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COMPLETENESS ASSERTION
All transactions that occurred during period are reported for the time period All accounts complete as to data Examples

Test whether all purchases goods, services are recorded Test whether all obligations included as liabilities
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RIGHTS & OBLIGATIONS ASSERTION

Entity entitled to assets (rights) Entity liable for obligations Example

Test whether all inventory is owned, not on consignment

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VALUATION OR ALLOCATION ASSERTION

Assets, liabilities, equities, revenues, expenses recorded at proper amounts Example

Test whether inventory valued at lower cost/market

Revenues, costs, expenses allocated to proper accounting periods

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PRESENTATION & DISCLOSURE ASSERTION

Financial statement components properly classified, described & disclosed Example

Test to assure financial statements, notes reveal substance of recorded transactions

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AUDIT PROCEDURES
Observation Documentation Confirmation Mechanical tests Analytical procedures (Comparisons) Inquiries
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RELATING OBJECTIVES TO OBSERVATION

Direct evidence about existence

Example: physically observing clients assets

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RELATING OBJECTIVES TO DOCUMENTATION

Internal evidence in documentary form to support existence,

valuation

Example: vouch documents supporting selected cash disbursements or liabilities

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RELATING OBJECTIVES TO CONFIRMATION

External evidence from third parties supporting

existence, valuation

of account balances
Example: request confirmation of accounts receivable
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RELATING OBJECTIVES TO MECHANICAL TESTS

Direct evidence to support

valuation

Example: recomputing (footing) cash receipts journal

Direct evidence to support

presentation

Example: trace transactions through accounting system for proper recording, classification
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RELATING OBJECTIVES TO COMPARISONS

Analytical procedures (Comparisons)

Direct evidence about

completeness, presentation, disclosure

Example: examine trends for advertising expense to determine whether more procedures necessary Example: compare disclosures with prior periods
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RELATING OBJECTIVES TO INQUIRIES

Direct evidence although less persuasive, may help generate leads

Corroborated through other procedures

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TESTS OF CONTROLS & SUBSTANTIVE TESTS

Tests of controls

Audit procedures to assess the ability of controls to prevent or detect material misstatements Provide evidence about control risk
Audit procedures that detect material misstatements Provide evidence about detection risk
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Substantive tests

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TESTS OF CONTROLS
Procedures address questions such as

How are controls applied? Are controls applied consistently? By whom are controls applied?

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TESTS OF CONTROLS & CONTROL RISK

Tests of controls are procedures to assess control risk Assessed level control risk helps determine acceptable level detection risk

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CATEGORIES OF CONTROL ACTIVITIES

Controls that create documentation, i.e., leave an audit trail

Managers initials for credit approval Prevention control Bank reconciliation provides no evidence of independence of preparer for cash function Detection control

Controls that do not create documentation

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COMBINED SUBSTANTIVE & CONTROL TESTS

Dual-purpose tests

Provide evidence about control risk & monetary error Example: recomputing extensions on sales invoices

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SUBSTANTIVE TESTS
Tests of details

Transactions Balances

Analytical tests

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ANALYTICAL PROCEDURES
Evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data

SAS No. 56
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TESTS OF DETAILS v. ANALYTICAL TESTS

Comparisons

Tests of details tests all 5 assertions but analytical procedures do not support existence or rights & obligations
Analytical procedures are high level tests

Tests of details lead to conclusions about aggregated data but analytical procedures test aggregated data
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USING ANALYTICAL PROCEDURES

When
Planning (required) Substantive tests

Purpose
Directs attention to likely misstatements Supports or refutes account balances Reviews reasonableness account balances

Overall review (required)

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TYPES ANALYTICAL PROCEDURES

Trend analysis Ratio analysis

Activity ratios Profitability ratios Liquidity ratios Solvency ratios Statistical tests, i.e., regression
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Modeling

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JUDGMENT ERRORS & ANALYTICAL PROCEDURES

Over reliance on unaudited numbers Disregard for unchanging account balances Overreliance on managements explanations

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CUSTOMER PERSPECTIVE & SKEPTICISM

Issue
Time Quality Performance

Professional skepticism
Declining on-time delivery rates Increasing customer complaints Increasing customer complaints

Cost
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Failure to be low-cost provider

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INTERNAL BUSINESS & SKEPTICISM

Issue
Development

Professional skepticism
Failure to be first to market

Quality
Productivity Core competencies
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Increasing defect rates

Unfavorable price, quantity variances Employees fail certification exams

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INTERNAL LEARNING & SKEPTICISM

Issue
Improved performance Innovation

Professional Skepticism
Poor performance against industry best practices Lagging product development

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COGNITIVE BIASES IN EVALUATING EVIDENCE

Heuristics: simplifying rules of thumb that may bias decision making

Representativeness Availability Anchoring-and-adjustment

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COGNITIVE BIASES:
Representativeness
Given an item, b, and a class of items, A, making a judgment based on how much b resembles other items from class A rather than making a judgment based on the probability that b came from class A.

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COGNITIVE BIASES:
Availability
The decision maker evaluates the likelihood of a particular outcome based on infrequent but highly publicized outcomes rather than outcomes predicted by the professions collected experience.

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COGNITIVE BIASES:

Anchoring-and-Adjustment
The decision maker assesses likelihood of an outcome with an initial, sometimes biased probability estimate (anchor) then adjusts the probability insufficiently when discovering new information.
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AUDIT DOCUMENTATION
ASB Standards
Auditors judgment about nature, extent of documentation depends on

Risk of misstatement Judgment about audit work Nature of procedures Significance of evidence Nature, extent of assertions tested

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AUDIT DOCUMENTATION
PCAOB

Reviewability standard
Derived from governmental standards Documents sufficient for experienced auditor to understand work performed, when, why Absent documentation of audit work, presumption that work not performed

Rebuttable presumption

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AUDIT DOCUMENTATION FILES

Correspondence (administrative) file Permanent file

Information of continuing interest & relevance Past, present, future income & property tax obligations

Tax file

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ROLE OF AUDIT DOCUMENTATION

Work was adequately planned, supervised, and reviewed (1st standard fieldwork) Internal control considered as basis for substantive tests (2nd standard fieldwork) Sufficient competent evidential matter was obtained (3rd standard fieldwork)
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AUTOMATED DOCUMENTATION
Spreadsheet software

Analytical procedures, data import/export, graphing, sorting

Database management

Relational structuring: combining 2 or more files for single query Access & retrieve electronically stored text

Text retrieval

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