Audit Evidence Chapter 6 PDF

Audit Evidence Chapter 6  Chapter 6: Audit Evidence Index Nature of Evidence................................................................................................................................. 4 Audit Evidence...

Audit Evidence Chapter 6  Chapter 6: Audit Evidence Index Nature of Evidence................................................................................................................................. 4 Audit Evidence Decisions...................................................................................................................... 5 Audit Program........................................................................................................................................ 6 Persuasiveness of Evidence................................................................................................................... 7 Relationships Among Audit Evidence and Persuasiveness................................................................... 8 Persuasiveness and Cost......................................................................................................................... 9 Types of Audit Evidence........................................................................................................................ 9 Audit Documentation........................................................................................................................... 14 The Effect of Technology.................................................................................................................... 15 References............................................................................................................................................ 16 2  Chapter 6: Audit Evidence Objectives By the end of this lesson the student is expected to be able to: 1. Introduce The nature of audit evidence. 2. Identify the four audit evidence decisions that are needed to create an audit program. 3. Specify the characteristics that determine the persuasiveness of evidence. 4. Identify the eight types of evidence used in auditing. 5. Introduce audit documentation. 6. Describe how technology affects auditing. 3  Chapter 6: Audit Evidence Nature of Evidence The use of evidence is not limited to auditors. There are six characteristics of evidence from the auditor's perspective: Comparison Items Audit of Financial Statements Use of the evidence. Determine whether statements are fairly presented. Nature of evidence used. Different types of audit evidence are generated by the auditor, third parties, and client. Parties evaluating evidence. Auditor. Certainty of conclusions from High level of assurance. the evidence. Nature of conclusions. Issue one of several alternative types of audit reports. Consequences of incorrect Statement users make incorrect decisions and conclusions from evidence. the auditor may be sued. Table 1: Nature of Evidence Gathering evidence is a large part of what auditors do. Evidences help auditors to draw conclusions. 4  Chapter 6: Audit Evidence Audit Evidence Decisions A major decision facing every auditor is determining the appropriate type and amounts of evidence needed to be satisfied that the clients' financial statements are fairly stated. The auditors must decide: 1. Which audit procedures to use: →Audit procedures An audit procedure is a detailed instruction that explains the audit evidence to be obtained during the audit. Example: the audit procedure for the verification of Cash disbursement: “Examine the cash disbursement journal and compare the payee name, amount, and date with online information provided by the bank about checks processed for the account. 2. What sample size to select for a given procedure: → Sample size Once a procedure is selected, auditors can vary the sample size from one to all the items in the population being tested. Example: In the audit procedure for the verification of Cash disbursement :“suppose 6600 checks are recorded in the cash disbursement journal, the auditor might select a sample size of 50 checks for comparison with the cash disbursement journal. 5  Chapter 6: Audit Evidence 3. Which items to select from the population: → Items to select Once sample size is selected for an audit procedure, the auditor must decide what item in the population to test. Example: In the audit procedure for the verification of Cash disbursement “. The auditor can select a week and examine the first 50 checks or select 50 checks with the largest amounts, or select the checks randomly or select those checks that the auditor thinks are most likely to be in error. 4. When to perform the procedures: →Timing The timing of audit procedures can vary from early in the accounting period to long after it has ended. The timing is also influenced by when the auditors believe the audit evidence will be most effective and when audit staff is available. Example: auditors often prefer to do counts of inventory as close to the balance sheet date as possible. Audit Program The audit program includes: 1. A list of the audit procedures, the auditor considers necessary. 2. Sample sizes. 3. Items to select. 6  Chapter 6: Audit Evidence 4. Timing of the tests. Example: Obtain the October cash disbursement journal and compare the payee name, amount, and date on the cancelled checks with the cash discernment journal for a randomly selected sample of 50 check. Most auditors use audit software packages to generate audit programs. Persuasiveness of Evidence The two determinants of the persuasiveness of evidence are : appropriateness and sufficiency. The persuasiveness of evidence can be evaluated only after considering the combination of appropriateness and sufficiency. Appropriateness of evidence is a measure of the quality of evidence, meaning its relevance and reliability in meeting audit objectives for classes of transactions, account balances, and related disclosures. If evidence is considered highly appropriate, it is a great help in persuading the auditor that financial statements are fairly stated. Note that Appropriateness cannot be improved by selecting a larger sample size or different population items. It can be improved only by selecting audit procedures that are more relevant or provide more reliable evidence. Sufficiency: The quantity of evidence obtained determines its sufficiency. Sufficiency of evidence is measured primarily by the sample size the auditor selects. For a given audit procedure, the evidence obtained from a sample of 100 is ordinarily more sufficient than from a sample of 50. 7  Chapter 6: Audit Evidence Relationships Among Audit Evidence and Persuasiveness Audit Evidence Decisions Qualities Affecting Persuasiveness of Evidence Audit procedures and timing Appropriateness Relevance Reliability Independence of provider Effectiveness of internal controls Auditor’s direct knowledge Qualifications of provider Objectivity of evidence Timeliness When procedures are performed Portion of period being audited Sample size and items to Sufficiency select Adequate sample size Selection of proper population items Table 2: Relationships Among Audit Evidence and Persuasiveness Evidence obtained from a source outside the entity is more reliable that that obtained from within.When a client’s internal controls are effective, evidence obtained is more reliable than when they are weak. Evidence obtained directly by the auditor through physical examination, observation, recalculation, and inspection is more reliable than information obtained indirectly. Although the source of information is independent the evidence will not be reliable unless the individual providing it is qualified to do so. 8  Chapter 6: Audit Evidence Objective evidence is more reliable than evidence that requires considerable judgment to determine whether it is correct. Timeliness of audit evidence can refer either to when it is accumulated or to the period covered by the audit. Persuasiveness and Cost persuasiveness and cost must be considered. It is rare when only one type of evidence is available for verifying information. The persuasiveness and cost of all alternatives should be considered before selecting the best type or types of evidence. The auditor’s goal is to obtain enough appropriate evidence at the lowest possible total cost. However, cost is never an adequate justification for omitting a necessary procedure or not gathering an adequate sample size. Types of Audit Evidence In deciding which audit procedures to use, the auditor can choose from eight categories of evidence, which are called types of evidence. Each audit procedure obtains one or more of the following types of evidence: 1. Physical examination. 2. Confirmation. 3. Documentation. 4. Analytical procedures. 5. Inquiries of the client. 6. Recalculation. 7. Reperformance. 8. Observation. 9  Chapter 6: Audit Evidence 1. Physical Examination It is the inspection or count by the auditor of a tangible asset. This type of evidence is most often associated with inventory and cash. Verify that An asset actually exists. Verify All the existing assets are recorded. One of the most useful and reliable types of Audit evidence. 2. Confirmations It is the receipt of a direct written response from a third party verifying the accuracy of the information that was requested by the auditor. One of the most useful and reliable types of Audit evidence The major types of information that are often confirmed, along with the source of the confirmation. Information Source Assets Cash in bank. Bank. Marketable securities. Investment custodian. Accounts receivable. Customer. Notes receivable. Maker. Owned inventory out on consignment. Consignment consignee. Inventory held in public warehouses. Public warehouses Public warehouse. Cash surrender value of life insurance. Insurance Insurance company. Liabilities Accounts payable. Creditor. 10  Chapter 6: Audit Evidence Notes payable. Lender. Advances from customers. Customer. Mortgages payable. Mortgagor. Bonds payable. Bondholder. Owners’ equity Shares outstanding. Register and transfer agent. Other information Insurance coverage. Insurance company. Contingent liabilities. Bank, lender, and client’s legal counsel. Bond indenture agreements. Bondholder. Collateral held by creditors. Creditor. Table 3: Confirmations 3. Documentation Documentation is the auditor’s inspection of the client’s documents and records to substantiate the information that is, or should be, included in the financial statements. The documents examined by the auditor are the records used by the client to provide information for conducting its business in an organized manner, and may be in paper form, electronic form, or other media. Internal documents are prepared and used within the client’s organization and are retained without ever going to an outside party. Documents can be classified as internal and external. An internal document has been prepared and used within the client’s organization and is retained without ever going to an outside party. Internal documents include duplicate sales invoices, employees’ time reports, and inventory receiving reports. 11  Chapter 6: Audit Evidence An external documents are handled by someone outside the client's organization who is a party to the transaction being documented but which are either currently held by the client or readily accessible. 4. Analytical Procedures Analytical procedures use comparisons and relationships to assess whether account balances or other data appear reasonable compared to the auditor’s expectations. For example; an auditor may compare the gross margin percent in the current year with the preceding year’s. Analytical procedures are used extensively in practice, and are required during the planning and completion phases of all audits. If the unusual fluctuation is large, the auditor must determine the reason and be satisfied that the cause is a valid economic event and not a misstatement. When no unusual fluctuations are noted, the risk of material misstatement is minimized. The purposes of analytical procedures are as follow: - Understand the client’s industry and business. - Assess the entity’s ability to continue as a going concern. - Indicate the presence of possible misstatements in the financial statements. - Reduce detailed audit tests. 5. Inquiries of the Client Inquiry is the obtaining of written or oral information from the client in response to questions from the auditor. it usually cannot be regarded as conclusive because it is not from an independent source and may be biased in the client’s favor. So when the auditor obtains evidence 12  Chapter 6: Audit Evidence through inquiry, it is normally necessary to obtain corroborating evidence through other procedures. (Corroborating evidence is additional evidence to support the original evidence.) when the auditor wants to obtain information about the client’s method of recording and controlling accounting transactions, the auditor usually begins by asking the client how the internal controls operate. Later, the auditor performs audit tests using documentation and observation to determine whether the transactions are recorded (completeness objective) and authorized (occurrence objective) in the manner stated. 6. Recalculation Recalculation involves rechecking a sample of calculations made by the client. Rechecking client calculations consists of testing the client’s arithmetical accuracy and includes such procedures as extending sales invoices and inventory, adding records, and checking the calculation of depreciation expense and prepaid expenses. A considerable portion of auditors’ recalculation is done by computer software. 7. Reperformance It is the auditor’s independent tests of client accounting procedures or controls that were originally done as part of the entity’s accounting and internal control system. Recalculation involves rechecking a computation. Reperformance involves checking other procedures. For example, the auditor may compare the price on an invoice to an approved price list or may reperform the aging of accounts receivable. Another type of reperformance is for the auditor to recheck transfers of information by tracing information included in more than one place to verify that it is recorded at the same amount each time. For example, the auditor normally makes limited tests to ascertain that the information in the sales journal has 13  Chapter 6: Audit Evidence been included for the proper customer and at the correct amount in the subsidiary accounts receivable records and is accurately summarized in the general ledger. 8. Observation Observation is rarely sufficient by itself because of the risk of client personnel changing their behavior because of the auditor’s presence. Use one’s senses to assess client activities. Tour plant to obtain a general impression of client’s facilities. Observation is rarely sufficient by itself. Often need to corroborate with another kind of evidence. Audit Documentation Audit documentation is the principal record of auditing procedures applied, evidence obtained, and conclusions reached by the auditor in the engagement. A CPA shall maintain documents received from clients, audit working papers and copies of financial statements pertaining to his clients for a minimum period of ten years from the date of issue of the audit report covering each financial year. Audit documentation, as it pertains to the current year’s audit, provides: - A basis for planning the audit. - A record of the evidence accumulated and the results of the tests. - Data for determining the proper type of audit report. - A basis for review by supervisors and partners. 14  Chapter 6: Audit Evidence The Effect of Technology Audit evidence is often available only in electronic form, and auditors must evaluate how this affects their ability to gather sufficient appropriate evidence. In certain instances, electronic evidence may exist only at a point in time. That evidence may not be retrievable later if files are changed and if the client lacks backup files. Therefore, auditors must consider the availability of electronic evidence early in the audit and plan their evidence gathering accordingly. Auditors use computers to read and examine evidence. Commercial audit software programs, such as ACL and Interactive Data Extraction and Analysis (IDEA) software, are designed specifically for use by auditors. Audit evidence is increasingly in electronic form. Auditors must evaluate how electronic information affects their ability to gather evidence. Auditors use computers to read and examine evidence. Software programs are typically windows-based. 15  Chapter 6: Audit Evidence References - Auditing and Assurance Services: An Integrated Approach,14th Edition - Alvin A Arens, Randal J Elder, Mark S Beasley, ISBN-13: 978-0-13-257595-9. ISBN-10: 0-13-257595-7 - Auditing Cases, International Edition (9th Edition) by Michael C. Knapp, ISBN-10: 1133187900. ISBN-13: 978-1133187905 16