AUDITINGCHAPTER 6

EvidenceByDavid N. Ricchiute

GBW 8th ed., Ch. 62

TOPICS

Acquisition & evaluation of evidenceFinancial statement assertions, audit objectives, & audit proceduresTests of controls, substantive tests, analytical procedures & nonfinancial measuresAudit documentation

GBW 8th ed., Ch. 63

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.

GBW 8th ed., Ch. 64

MEANING OF SUFFICIENT, COMPETENT EVIDENCE

Sufficient: quantity of evident necessary to test management’s assertionsCompetent: relevant, valid, reliable Kinds of evidence necessary to test

management’s assertions

Link audit risk & audit evidence Relevance Amount of evidence

GBW 8th ed., Ch. 65

EVIDENTIAL MATTERUnderlying accounting data Records of original entry (journals,

ledgers, etc.) Data files Spreadsheets

Corroborating information Documents (checks, invoices, contracts) Written representations from 3rd parties

(vendors, attorneys) Inquiries of management

GBW 8th ed., Ch. 66

FINANCIAL STATEMENT ASSERTIONS

Existence or OccurrenceCompletenessRights & ObligationsValuation or AllocationPresentation & Disclosure

GBW 8th ed., Ch. 67

ACCOUNTS & JOURNAL ENTRIES

Purchase & sale of inventoryInventory Accounts payable

Cost of Goods Sold Inventory

GBW 8th ed., Ch. 68

EXISTENCE OR OCCURRENCE ASSERTION

All assets, liabilities, equities existAll transactions occurredExample Test whether inventory physically

existed at balance sheet date

GBW 8th ed., Ch. 69

COMPLETENESS ASSERTION

All transactions that occurred during period are reported for the time periodAll accounts complete as to dataExamples Test whether all purchases goods,

services are recorded Test whether all obligations included as

liabilities

GBW 8th ed., Ch. 610

RIGHTS & OBLIGATIONS ASSERTION

Entity entitled to assets (rights)Entity liable for obligations Example Test whether all inventory is

owned, not on consignment

GBW 8th ed., Ch. 611

VALUATION OR ALLOCATION ASSERTION

Assets, liabilities, equities, revenues, expenses recorded at proper amountsExample Test whether inventory valued at

lower cost/market

Revenues, costs, expenses allocated to proper accounting periods

GBW 8th ed., Ch. 612

PRESENTATION & DISCLOSURE ASSERTION

Financial statement components properly classified, described & disclosedExample Test to assure financial

statements, notes reveal substance of recorded transactions

GBW 8th ed., Ch. 613

AUDIT PROCEDURES

ObservationDocumentationConfirmationMechanical testsAnalytical procedures (Comparisons)Inquiries

GBW 8th ed., Ch. 614

RELATING OBJECTIVES TO OBSERVATION

Direct evidence about existence Example:

physically observing client’s assets

GBW 8th ed., Ch. 615

RELATING OBJECTIVES TO DOCUMENTATION

Internal evidence in documentary form to support existence, valuation Example: vouch

documents supporting selected cash disbursements or liabilities

GBW 8th ed., Ch. 616

RELATING OBJECTIVES TO CONFIRMATION

External evidence from third parties supporting existence, valuation of account balances Example: request

confirmation of accounts receivable

GBW 8th ed., Ch. 617

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

GBW 8th ed., Ch. 618

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

GBW 8th ed., Ch. 619

RELATING OBJECTIVES TO INQUIRIES

Direct evidence although less persuasive, may help generate leads Corroborated

through other procedures

GBW 8th ed., Ch. 620

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

Substantive tests Audit procedures that detect material

misstatements Provide evidence about detection risk

GBW 8th ed., Ch. 621

TESTS OF CONTROLS

Procedures address questions such as How are controls applied? Are controls applied consistently? By whom are controls applied?

GBW 8th ed., Ch. 622

TESTS OF CONTROLS & CONTROL RISK

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

GBW 8th ed., Ch. 623

CATEGORIES OF CONTROL ACTIVITIES

Controls that create documentation, i.e., leave an audit trail Manager’s initials for credit approval Prevention control

Controls that do not create documentation Bank reconciliation provides no evidence of

independence of preparer for cash function Detection control

GBW 8th ed., Ch. 624

COMBINED SUBSTANTIVE & CONTROL TESTS

Dual-purpose tests Provide evidence about

control risk & monetary error

Example: recomputing extensions on sales invoices

GBW 8th ed., Ch. 625

SUBSTANTIVE TESTS

Tests of details Transactions Balances

Analytical tests

GBW 8th ed., Ch. 626

ANALYTICAL PROCEDURES

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

SAS No. 56

GBW 8th ed., Ch. 627

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

GBW 8th ed., Ch. 628

USING ANALYTICAL PROCEDURES

When Purpose

Planning (required) Directs attention to likely misstatements

Substantive tests Supports or refutes account balances

Overall review (required)

Reviews reasonableness account balances

GBW 8th ed., Ch. 629

TYPES ANALYTICAL PROCEDURES

Trend analysisRatio analysis Activity ratios Profitability ratios Liquidity ratios Solvency ratios

Modeling Statistical tests, i.e., regression

GBW 8th ed., Ch. 630

JUDGMENT ERRORS & ANALYTICAL PROCEDURES

Over reliance on unaudited numbersDisregard for unchanging account balancesOverreliance on management’s explanations

GBW 8th ed., Ch. 631

CUSTOMER PERSPECTIVE & SKEPTICISM

Issue Professional skepticism

Time Declining on-time delivery rates

Quality

Performance

Increasing customer complaintsIncreasing customer complaints

Cost Failure to be low-cost provider

GBW 8th ed., Ch. 632

INTERNAL BUSINESS & SKEPTICISM

Issue Professional skepticismDevelopment Failure to be first to market

Quality Increasing defect rates

Productivity Unfavorable price, quantity variances

Core competencies

Employees fail certification exams

GBW 8th ed., Ch. 633

INTERNAL LEARNING & SKEPTICISM

Issue Professional Skepticism

Improved performance

Poor performance against industry best practices

Innovation Lagging product development

GBW 8th ed., Ch. 634

COGNITIVE BIASES IN EVALUATING EVIDENCE

Heuristics: simplifying rules of thumb that may bias decision making Representativeness Availability Anchoring-and-adjustment

GBW 8th ed., Ch. 635

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.

GBW 8th ed., Ch. 636

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 profession’s collected experience.

GBW 8th ed., Ch. 637

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.

GBW 8th ed., Ch. 638

AUDIT DOCUMENTATIONASB Standards

Auditor’s 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

GBW 8th ed., Ch. 639

AUDIT DOCUMENTATIONPCAOB

Reviewability standard Derived from governmental standards Documents sufficient for experienced

auditor to understand work performed, when, why

Rebuttable presumption Absent documentation of audit work,

presumption that work not performed

GBW 8th ed., Ch. 640

AUDIT DOCUMENTATION FILES

Correspondence (administrative) filePermanent file Information of continuing interest &

relevance

Tax file Past, present, future income &

property tax obligations

GBW 8th ed., Ch. 641

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)

GBW 8th ed., Ch. 642

AUTOMATED DOCUMENTATION

Spreadsheet software Analytical procedures, data

import/export, graphing, sorting

Database management Relational structuring: combining

2 or more files for single query

Text retrieval Access & retrieve electronically

stored text