AUDIT PROCEDURES

Substantive Testing and Evidence

Evidence• Evidence is anything that can make a person believe that a fact, proposition, or assertion is true or false.

• Audit evidence is all of the information used by the auditor in arriving at the conclusions on which the audit opinion is which the audit opinion is based. (ISA 500)

– It includes the accounting records and other information underlying the financial statements.

Audit evidence is different from the legal evidence.

�In a civil lawsuit, evidence must be

strong enough to incline a person

to believe one side or the other.

� In a criminal case evidence must

establish proof of a crime beyond a establish proof of a crime beyond a

reasonable doubt.

�Audit evidence provides only

reasonable assurance

Accounting records generally include the records of initial entries

and supporting records.

• Initial entries include: records of initial entries such as checks and electronic

fund transfers; contracts, invoices; shipping notices, purchase orders, sales orders, the general and subsidiary ledgers, journal entries and other adjustments to the financial statements.adjustments to the financial statements.

• Supporting records examples are computer files, databases, work sheets, spreadsheets, computer and manual logs, computations, reconciliations, and disclosures. evidence

The auditor obtains audit evidence to draw reasonable conclusions

on which to base the audit opinion by performing audit procedures

to:

� Obtain an understanding of the entity and its

environment, including its internal control, to assess the

risks of material misstatement at the financial statement

and assertion levels (“risk assessment procedures”);

� Test the operating effectiveness of controls in preventing, � Test the operating effectiveness of controls in preventing,

or detecting and correcting, material misstatements at the

assertion level (“tests of controls”); and

� Detect material misstatements at the assertion level

(“substantive procedures”) – ISA 500

Substantive Procedures

Defined

Substantive procedures are tests performed to obtain audit evidence to detect material misstatements at the assertion level.

Two types –Two types –

(1) tests of details of classes of transactions, account balances, and disclosures and

(2) analytical procedures

Legal Proof and Evidence

• Legal standards of proof– beyond a reasonable doubt – preponderance of evidence – clear and convincing evidence– probable cause

• Legal evidence– proof results direct or circumstantial– Source

• real tangible and can be presented to a court for inspection

• testimonial evidence given by witnesses under oath.

• original documentary evidence

ASSERTIONS about classes of transactions and events for the period under

audit

Occurrence Transactions and events that have been recorded have occurred and pertain to the entity.

Completeness All transactions and events that should have been recorded have been recorded.

Accuracy Amounts and other data relating to recorded transactions and events have been recorded transactions and events have been recorded accurately.

Cutoff Transactions and events have been recorded in the correct accounting period

Classification Transactions and events have been recorded in the proper accounts

Illustration 10.2

ASSERTIONS about account balances at the period end

Existence Assets, liabilities, and equity interests exist

Rights and obligations The entity holds or controls the rights to assets and liabilities are the obligations of the entity

Completeness All assets, liabilities and equity interests that should have been recorded have been should have been recorded have been recorded

Valuation and Allocation

Assets, liabilities and equity interests are included in the financial statements at appropriate amounts and any resulting valuation adjustments are appropriately recorded

Illustration 10.2

ASSERTIONS about presentation and disclosure

Occurrence and rights and obligations

Disclosed matters have occurred and pertain to the entity.

Completeness All disclosures that should have been included in the financial statements have been included

Classification and understandability(not in text)

financial information is appropriately presented and described, and disclosures are clearly expressed

Accuracy and valuation

Financial and other information are disclosed fairly and at appropriate amountsIllustration 10.2

• Sufficiency is the measure of the quantityof audit evidence

• Appropriateness is the measure of qualityof

Sufficient Appropriate Audit Evidence

• Appropriateness is the measure of qualityof audit evidence, its reliability, & its relevancein providing support for, or detecting, misstatements in transactions, balances, disclosures and related assertions

• Relevance of evidence is the appropriateness (pertinence) of the evidence to the audit objective being tested.

• Reliability is the quality of information when it is free from material error and bias and can be depended upon and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent.

Reliability of audit evidence

� Audit evidence obtained directly by the auditor (e.g., observation, re-performance) is more reliable than audit evidence obtained indirectly or by inference.

� Audit evidence is more reliable when it exists in documentary form, whether paper, electronic, or other medium.

� Audit evidence is more reliable when it is obtained from � Audit evidence is more reliable when it is obtained from independent sources outside the entity..

� Audit evidence provided by original documents is more reliable than audit evidence provided by photocopies or facsimiles.

� The effectiveness of the client’s internal control structure has a significant impact on reliability of evidence.

Information Provided by the Auditee

When information produced by the entity is used by the auditor to perform audit procedures, the procedures, the auditor should obtain audit evidence about the accuracy and completeness of the information.

Nature of Substantive procedures

� Tests of details of transactions are

audit procedures related to examining

the processing of particular classes of

transactions through the accounting

systems.systems.

� Tests of balances are substantive tests that

provide either reasonable assurance of the

validity of a general ledger balance or

identifies a misstatement in the account.

� Analytical procedures

Tests of Balances

� Tests of Balances are used to examine the actual details making up high turnover accounts such as cash, Accounts Receivable, Accounts Payable, etc..

Why is tests of balances so important?Why is tests of balances so important?

� Because the auditor’s ultimate objective is to express an opinion on financial statements that are made up of account balances.

Tests of Balances

In tests of balances the auditor is concerned with overstatement or understatement of the line item in the financial statement.

� Test makes use of the inherent properties of double-entry accounting systems.of double-entry accounting systems.

� From the auditor’s perspective, this means that a test of one side of the transaction simultaneously tests the other side of the transactions.

Audit Procedures for Gathering Evidence

• Evidence-gathering techniques are techniques employed by an auditor to obtain evidence.

• Evidence-gathering techniques are:

– Inquiry

– Observation

– Inspection (physical evidence and examination of – Inspection (physical evidence and examination of

documents)

– Recalculation

–– ReperformanceReperformance

– Confirmation

– Analytical procedures.

–

Inquiry consists of seeking information of knowledgeable persons inside (client) or outside the entity.

Largest amount of audit evidence in an audit is obtained from client inquirycannot be regarded as conclusive because it is not from

Inquiry

cannot be regarded as conclusive because it is not from an independent source and might be biased

the auditor must gather evidence to corroborate inquiry evidence by doing other alternative procedures.

Observation

�Observation consists of looking at a process or procedure being performed by others.

� For example, the observation by the � For example, the observation by the auditor of the counting of inventories by the entity’s personnel or by the performance of internal control procedures that leave no audit trail.

�Observation should be supported by other types of evidence.

count of physical

inventory

• ISA 501 “When inventory is material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding its existence and condition by attendance at physical inventory and condition by attendance at physical inventory counting.”

• If unable to attend the physical inventory count, the auditor should take or observe some physical counts on an alternative date and, when necessary, perform tests of controls of intervening transactions.

Alternative procedures for attending physical inventory

include Auditor review of:

� Management’s instructions regarding the application of control procedures (e.g. collection of used stock sheets, accounting for unissued stock sheets and count and re-count procedures);

� Accurate identification of the stage of completion � Accurate identification of the stage of completion of work in progress, of slow-moving, obsolete, or damaged items and items on consignment

� Whether appropriate arrangements are made regarding the movement of inventory between areas and the shipping and receipt of inventory before and after the cutoff date.

Inspection

Inspection is the auditor's examination of the

client's documents records or tangible assets

to substantiate the important information

related to the financial statements.related to the financial statements.

Internal documents and external documents.

�Internal documents processed under good internal

controls are more reliable than those processed

under weak controls.

�External documents may be processed by both internal documents

and external parties representing agreement.

�External documents like title to property, insurance

policies and contracts are very reliable evidence.

Vouching and Tracing

� Vouching is the use of documentation to support

recorded transactions or amounts. It is an

audit process whereby the auditor selects sample

items from an account and goes backward through

the accounting system to find the source

documentation that supports the item selected.documentation that supports the item selected.

� Tracing is an audit procedure whereby the auditor

selects sample items from basic source documents

and proceeds forward through the accounting system

to find the final recording of the transactions (e.g., in

the ledger).

Recalculation & Reperformance

Recalculation consists of checking the arithmetical accuracy of source documents and accounting records or of performing independent calculations.

Reperformance is the auditor’s independent execution of

Reperformance is the auditor’s independent execution of procedures or controls that were originally performed as part of the entity’s internal control, either manually or through the use of CAATs.

Recalculation

Examples:

� Extending sales invoices

� Adding journals and subsidiary records

� Checking calculations of depreciation� Checking calculations of depreciation

� Checking mechanical accuracy of

records and ledgers.

CONFIRMATION

Defined: It is the auditor’s receipt of a written or oral

response from a independent third party verifying the

accuracy or the information requested.

Four Key Characteristics:Four Key Characteristics:

1. Information is requested by auditor.

2. Request and response is in writing, sent to the auditor.

3. Response comes from an independent third party.

4. Positive confirmation involves a receipt of information.

Confirmation

An auditor may use a confirmation in response to a

significant risk

The auditor must ordinarily confirm accounts receivable.

. Written confirmations received from third parties are

highly persuasive, but very costly and an inconvenience highly persuasive, but very costly and an inconvenience

for those who are asked to supply them.

Positive confirmation: Asks the

recipient (debtor, creditor or other third

party) to confirm agreement or to

express disagreement with the recorded

balance.

Reliable evidence

Negative confirmation: A reply is Negative confirmation: A reply is

requested only in the event of

disagreement with the recorded

balance.

Use for large number small balances,

low control risk, response is expected

Search for unrecorded liabilities

Defined:

�A substantive test usually performed on accounts payableis a search for unrecorded liabilities.

� This test provides evidence as a completeness and some evidence as to valuation.evidence as to valuation.

�By reviewing cash disbursements subsequent to the balance sheet date, the auditor has a good idea of the potential population of unrecorded accounts payable.

Reliability of Procedures

A list of the most reliable most reliable to the least reliable least reliable evidence

gathering techniques are in general:

1 Recalculation

2. Inspection.

3 Reperformance.3 Reperformance.

4 Observation.

5 Confirmation.

6 Analytical procedures.

7 Inquiry.

Cost of Procedures

• The auditor considers the relationship between the cost of obtaining audit evidence and the usefulness of the information obtained. The evidence-gathering procedures in order of cost from most costly to least costly are in general:

1 Confirmation.

2 Inspection.

3 Recalculation3 Recalculation

4. Reperformance

5 Observation.

6 Analytical procedures.

7 Inquiry.