Audit Evidence and Documentation

1. Audit Evidence and Documentation

2. The Third Standard of Field Work Sufficient appropriateevidential matter is to obtained by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit.

3. Management Assertions Embodied in the Financial Statements • Existence or Occurrence--Assets, liabilities, and owners’ equity accounts reflected in the financial statements exist; the recorded transactions have occurred. • Completeness--All transactions, assets, liabilities, and elements of owners’ equity that should be presented in the financial statements are included. • Rights and Obligations--The client has rights to assets and obligations to pay liabilities that are included in the financial statements. • Valuation or Allocation--Assets, liabilities, owners’ equity, revenues, and expenses are presented at amounts that are determined in accordance with generally accepted accounting principles. • Presentation and Disclosure--Accounts are described and classified in the financial statements in accordance with generally accepted accounting principles, and all material disclosures are provided. • Accuracy – Amounts and other data relating to recorded transactions have been recorded properly. • Cutoff – Transactions have been recorded in the proper accounting period.

4. Financial Statements (GAAP) Management Assertions Audit Objectives Audit Evidence Audit Report on Financial Statements Audit Procedures Relationship of Financial Statement Assertions and the Audit

5. Audit Risk Risk of Material Risk that the Auditors Audit Risk = Misstatement * Fail to Detect the Misstatement = Inherent Control Detection Risk * Risk * Risk

6. Inherent Risk The risk of a material misstatement occurring in an assertion assuming no related internal controls. Related to: • Nature of the client or industry • Nature of the financial statement account

7. 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.

8. 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. Detection risk restricted by performing substantive tests

9. Audit Risk Formula AR = IR x CR x DR AR = Audit risk IR = Inherent risk CR = Control risk DR = Detection risk

10. Illustration of Audit Risk

11. Audit Risk FormulaSolving for Detection Risk • Implications • Assuming constant, sufficiently low AR, detection risk is inversely related to IR and CR ↑ combined IR and CR ↓ allowed DR ↑ substantive evidence

12. Audit Evidence Evidential matter: any information that corroborates or refutes an assertion

13. Types of Evidence • Physical evidence • Third-party representations • Documentary evidence • Computations • Data Interrelationships • Client representations • Accounting records

14. Types of EvidencePhysical Evidence Evidence that can actually be seen by auditors. • This type of evidence is generally effective for supporting the existence assertion.

15. Types of EvidenceThird Party Representations • Confirmations • Lawyers’ Letters • Reports of Specialists

16. Types of EvidenceDocumentary Evidence Four basic types (helps determine competence): • Created by outside parties and transmitted directly to auditor • Created by outside parties and held by client • Created and held by client • Electronic documents

17. Types of EvidenceComputations Computations are: • performed independently by auditor • used to verify mathematical accuracy of client’s analyses and records

18. Types of EvidenceData Interrelationships Data interrelationships (i.e., analytical procedures) rely on plausible relationships among financial and non-financial data. • Effective for testing “reasonableness” of certain account balances • Can be used as primary or corroborating evidence, depending on the nature of account

19. Types of EvidenceOral and Written Client Representations • Responses to questions and inquiries to clients during an audit constitute audit evidence. • Oral representations are generally not sufficient as primary evidence, but may provide corroboration for other evidence. • Written representations (representation letter) are required, but should not be used as a substitute for other audit procedures.

20. Types of EvidenceAccounting Records Clients’ accounting records (e.g. ledgers and journals) may provide worthwhile evidence in themselves. • Depends on the effectiveness of internal controls

21. Audit Procedures • Physical examination • Observation • Confirmation • Tracing • Vouching • Inspection • Reconciliation • Reperformance • Analytical procedures • Inquiry • Comparison Physical Evidence Third-Party Representations Documentary Evidence Computations Data Interrelationships Client Representations Accounting Records

22. Competence of Evidential Matter • To be competent evidence must be: • Relevant • Must relate to the audit objective • Valid (Reliable) • Independent sources have greater reliability than those within the client organization. • Strong internal control increases reliability of evidence created within the client organization. • Directly obtained evidence is more reliable than evidence obtained second hand.

23. Reliability of Certain Types of Audit Evidence • RELIABILITY TYPE EXAMPLE • High Physical Inventory Observation • Documentary • External Cutoff Bank Statement • External/Internal Purchase Invoice • Internal Sales Invoice • Low Client Representations Management Representation • Letter

24. Basic Approaches to Auditing Accounting 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.

25. Functions of Working Papers • Provide support for the auditors’ opinion • Document the auditors’ compliance with generally accepted auditing standards, especially the standards of field work • Provide a means of assigning and coordinating audit work • Aid in supervising and reviewing the audit work • Aid in planning and conducting future audits

26. Types of Working Papers • Audit Administrative Working Papers • Working Trial Balance • Lead Schedules (Grouping Sheets) • Adjusting and Reclassification Journal Entries • Supporting Schedules • Account Analysis • Reconciliations • Computational Working Papers • Corroborating Documents

27. Types of Working Files • Current files • Typically arranged and indexed around accounts in clients’ financial statement • Support current year’s audit report • Permanent files • Document items of concern over multiple years • Provide summary of policies and organization of client • To preserve working papers that have little change over time.

30. SARBOX Perspective • SARBOX requires the creation and maintenance, for a period of no less than seven years, of audit working papers sufficient to support the audit report. • Deliberate destruction of the audit documentation within the seven year period constitutes a criminal offense.

31. More on Analytical Procedures • Required during planning and review stages of an audit • Analytical procedure process • Develop an expectation (amount or ratio) • Vertical analysis (common-size statements) • Horizontal (trend) analysis • Cross-sectional (industry) analysis • Determine acceptable difference • Compare actual results with expectation • Investigate significant differences