Audit Evidence, Audit Planning and Documentation (Week Four) PDF

AUDIT PRACTICE AND PROCEDURES II Audit Evidence; Audit Planning and Documentation Week Four  What Is Auditing Evidence? The foundation of any audit is the evidence obtained and evaluated by the auditor. The auditor must have th...

AUDIT PRACTICE AND PROCEDURES II Audit Evidence; Audit Planning and Documentation Week Four  What Is Auditing Evidence? The foundation of any audit is the evidence obtained and evaluated by the auditor. The auditor must have the knowledge and skill to accumulate sufficient appropriate evidence on every audit to meet the standards of the profession. Evidence was defined in Chapter 1 as any information used by the auditor to determine whether the information being audited is stated in accordance with the established criteria. Auditing evidence is the information collected for review of a company's financial transactions, internal control practices, and other items necessary for the certification of financial statements by an auditor or certified public accountant (CPA). The amount and type of auditing evidence considered vary considerably based on the type of firm being audited as well as the required scope of the audit.  Audit Evidence Decisions If you think about the multitude of work involved in auditing, it stands to reason then that the gathering of audit evidence is critical to this process. Therefore, the auditor will have to determine a number of factors before they proceed. There are four decisions about what evidence to gather and how much of it to accumulate: 1. Which audit procedures to use 2. What sample size to select for a given procedure 3. Which items to select from the population 4. When to perform the procedures  Audit Evidence Decisions Cont’d Audit Procedures - An audit procedure is the detailed instruction that explains the audit evidence to be obtained during the audit. It is common to spell out these procedures in sufficiently specific terms so an auditor may follow these instructions during the audit. For example, the following is an audit procedure for the verification of cash disbursements: Examine the cash disbursements journal in the accounting system and compare the payee, name, amount, and date with online information provided by the bank about checks processed for the account Sample Size - Once an audit procedure is selected, auditors can vary the sample size from one to all the items in the population being tested. In an audit procedure to verify cash disbursements, suppose 6,600 checks are recorded in the cash disbursements journal. The auditor might select a sample size of 50 checks for comparison with the cash disbursements journal. The decision of how many items to test must be made by the auditor for each audit procedure. The sample size for any given procedure is likely to vary from audit to audit, depending on client characteristics such as the extent of automated controls and the required level of assurance from the procedure.  Audit Evidence Decisions Cont’d Items to Select - After determining the sample size for an audit procedure, the auditor must decide which items in the population to test. If the auditor decides, for example, to select 50 cancelled checks from a population of 6,600 for comparison with the cash disbursements journal, several different methods can be used to select the specific checks to be examined. The auditor can (1) select a week and examine the first 50 checks, (2) select the 50 checks with the largest amounts, (3) select the checks randomly, or (4) select those checks that the auditor thinks are most likely to be in error. Or, a combination of these methods can be used.  Audit Evidence Decisions Cont’d Timing - An audit of financial statements usually covers a period such as a year. Normally, an audit is not completed until several weeks or months after the end of the period. The timing of audit procedures can therefore vary from early in the accounting period to long after it has ended. In part, the timing decision is affected by when the client needs the audit to be completed. In the audit of financial statements, the client normally wants the audit completed 1 to 3 months after year-end. The SEC currently requires that all public companies file audited financial statements with the SEC within 60 to 90 days of the company’s fiscal year-end, depending on the company’s size. However, timing is also influenced by when the auditor believes the audit evidence will be most effective and when audit staff is available. For example, auditors often prefer to do counts of inventory as close to the balance sheet date as possible.  Audit Evidence Decisions Cont’d Audit procedures often incorporate sample size, items to select, and timing into the procedure. The following is a modification of the audit procedure previously used to include all four audit evidence decisions. (Italics identify the timing, items to select, and sample size decisions.) Obtain the October cash disbursements journal and compare the payee name, amount, and date on the cancelled check with the cash disbursements journal for a randomly selected sample of 40 check numbers  Persuasiveness of Evidence Audit standards require the auditor to accumulate sufficient appropriate evidence to support the opinion issued. Because of the nature of audit evidence and the cost considerations of doing an audit, it is unlikely that the auditor will be completely convinced that the opinion is correct. However, the auditor must be persuaded that the opinion is correct with a high level of assurance. By combining all evidence from the entire audit, the auditor is able to decide when he or she is persuaded to issue an audit report. The two determinants of the persuasiveness of evidence are 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 of evidence deals only with the audit procedures selected. 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 Relevance of Evidence - Evidence must pertain to or be relevant to the audit objective that the auditor is testing before it can be appropriate. For example, assume that the auditor is concerned that a client is failing to bill customers for shipments (completeness transaction objective). If the auditor selects a sample of duplicate sales invoices and traces each to related shipping documents, the evidence is not relevant for the completeness objective and therefore is not appropriate evidence for that objective. A relevant procedure is to trace a sample of shipping documents to related duplicate sales invoices to determine whether each shipment was billed. The second audit procedure is relevant because the shipment of goods is the normal criterion used for determining whether a sale has occurred and should have been billed. By tracing from shipping documents to duplicate sales invoices, the auditor can determine whether shipments have been billed to customers. In the first procedure, when the auditor traces from duplicate sales invoices to shipping documents, it is impossible to find unbilled shipments. Relevance can be considered only in terms of specific audit objectives, because evidence may be relevant for one audit objective but not for a different one. In the previous shipping example, when the auditor traced from the duplicate sales invoices to related shipping documents, the evidence was relevant for the occurrence transaction objective. Most evidence is relevant for more than one, but not all, audit objectives. Reliability of Evidence - Reliability of evidence refers to the degree to which evidence can be believable or worthy of trust. Like relevance, if evidence is considered reliable it is a great help in persuading the auditor that financial statements are fairly stated. For example, if an auditor counts inventory, that evidence is more reliable than if management gives the auditor its own count amounts. Reliability, and therefore appropriateness, depends on the following six characteristics of reliable evidence: 1. Independence of provider. Evidence obtained from a source outside the entity is more reliable than that obtained from within. Communications from banks, attorneys, or customers is generally considered more reliable than answers obtained from inquiries of the client. Similarly, documents that originate from outside the client’s organization, such as an insurance policy, are considered more reliable than are those that originate within the company and have never left the client’s organization, such as a purchase requisition. 2. Effectiveness of client’s internal controls - When a client’s internal controls are effective, evidence obtained is more reliable than when they are not effective. For example, if internal controls over sales and billing are effective, the auditor can obtain more reliable evidence from sales invoices and shipping documents than if the controls were inadequate. 3. Auditor’s direct knowledge - Evidence obtained directly by the auditor through physical examination, observation, recalculation, and inspection is more reliable than information obtained indirectly. For example, if the auditor calculates the gross margin as a percentage of sales and compares it with previous periods, the evidence is more reliable than if the auditor relies on the calculations of the controller. 4. Qualifications of individuals providing the information - Although the source of information is independent, the evidence will not be reliable unless the individual providing it is qualified to do so. Therefore, communications from attorneys and bank confirmations are typically more highly regarded than accounts receivable confirmations from persons not familiar with the business world. Also, evidence obtained directly by the auditor may not be reliable if the auditor lacks the qualifications to evaluate the evidence. For example, examining an inventory of diamonds by an auditor not trained to distinguish between diamonds and cubic zirconia is not reliable evidence for the existence of diamonds. 5. Degree of objectivity - Objective evidence is more reliable than evidence that requires considerable judgment to determine whether it is correct. Examples of objective evidence include confirmation of accounts receivable and bank balances, the physical count of securities and cash, and adding (footing) a list of accounts payable to determine whether it agrees with the balance in the general ledger. Examples of subjective evidence include a letter written by a client’s attorney discussing the likely outcome of outstanding lawsuits against the client, observation of obsolescence of inventory during physical examination, and inquiries of the credit manager about the collectibility of noncurrent accounts receivable. When the reliability of subjective evidence is being evaluated, it is essential for auditors to assess the qualifications of the person providing the evidence. Timeliness - The timeliness of audit evidence can refer either to when it is accumulated or to the period covered by the audit. Evidence is usually more reliable for balance sheet accounts when it is obtained as close to the balance sheet date as possible. For example, the auditor’s count of marketable securities on the balance sheet date is more reliable than a count 2 months earlier. For income statement accounts, evidence is more reliable if there is a sample from the entire period under audit, such as a random sample of sales transactions for the entire year, rather than from only a part of the period, such as a sample limited to only the first 6 months  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. Several factors determine the appropriate sample size in audits. The two most important ones are the auditor’s expectation of misstatements and the effectiveness of the client’s internal controls. To illustrate, assume in the audit of Jones Computer Parts Co. that the auditor concludes that there is a high likelihood of obsolete inventory because of the nature of the client’s industry. The auditor will sample more inventory items for obsolescence in this audit than one where the likelihood of obsolescence is low. Similarly, if the auditor concludes that a client has effective rather than ineffective internal controls over recording fixed assets, a smaller sample size in the audit of acquisitions of fixed assets may be warranted.  Types of Audit Evidence In deciding which audit procedures to use, the auditor can choose from eight broad categories of evidence, which are called types of evidence. Every audit procedure obtains one or more of the following types of evidence: 1. Physical examination 2. Confirmation 3. Inspection 4. Analytical procedures 5. Inquiries of the client 6. Recalculation 7. Reperformance 8. Observation Physical examination is the inspection or count by the auditor of a tangible asset. This type of evidence is most often associated with inventory and cash, but it is also applicable to the verification of securities, notes receivable, and tangible fixed assets. Physical examination is a direct means of verifying that an asset actually exists (existence objective), and to a lesser extent whether existing assets are recorded (completeness objective). It is considered one of the most reliable and useful types of audit evidence. Generally, physical examination is an objective means of ascertaining both the quantity and the description of the asset. In some cases, it is also a useful method for evaluating an asset’s condition or quality. However, physical examination is not sufficient evidence to verify that existing assets are owned by the client (rights and obligations objective), and in many cases the auditor is not qualified to judge qualitative factors such as obsolescence or authenticity (realizable value objective). Also, proper valuation for financial statement purposes usually cannot be determined by physical examination (accuracy objective). Confirmation describes the receipt of a direct written response from a third party verifying the accuracy of information that was requested by the auditor. The response may be in paper form or electronic or other medium, such as the auditor’s direct access to information held by the third party. The request is made to the client, and the client asks the third party to respond directly to the auditor. Because confirmations come from third-party sources instead of the client, they are a highly regarded and often-used type of evidence. Inspection is the auditor’s examination 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. Documentation is widely used as evidence in audits because it is usually readily available at a relatively low cost. Sometimes, it is the only reasonable type of evidence available. 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. An external document has been handled by someone outside the client’s organization who is a party to the transaction being documented, but which is either currently held by the client or readily accessible. Analytical procedures consist of evaluations of financial information through analysis of plausible relationships among financial and nonfinancial data. 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 on all audits. Inquiry is the obtaining of written or oral information from the client in response to questions from the auditor. Although considerable evidence is obtained from the client through inquiry, it usually cannot be regarded as conclusive because it is not from an independent source and may be biased in the client’s favor. Therefore, when the auditor obtains evidence through inquiry, it is normally necessary to obtain corroborating evidence through other procedures. (Corroborating evidence is additional evidence to support the original evidence.) 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 journals and subsidiary records, and checking the calculation of depreciation expense and prepaid expenses. A considerable portion of auditors’ recalculation is done by computer-assisted audit software. Reperformance 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. Whereas 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. Observation consists of looking at a process or procedure being performed by others. The auditor may tour the plant to obtain a general impression of the client’s facilities, or watch individuals perform accounting tasks to determine whether the person assigned a responsibility is performing it properly. Observation provides evidence about the performance of a process or procedure but is limited to the point in time at which the observation takes place. Observation is rarely sufficient by itself because of the risk of client personnel changing their behavior because of the auditor’s presence. They may perform their responsibilities in accordance with company policy but resume normal activities once the auditor is not in sight. Chapter 8 – Audit Planning  Audit Planning The auditor must plan the work and properly supervise any assistants. There are three main reasons why the auditor should properly plan engagements: to enable the auditor to obtain sufficient appropriate evidence for the circumstances, to help keep audit costs reasonable, and to avoid misunderstandings with the client. Obtaining sufficient appropriate evidence is essential if the CPA firm is to minimize legal liability and maintain a good reputation in the business community. Keeping costs reasonable helps the firm remain competitive. Avoiding misunderstandings with the client is necessary for good client relations and for facilitating high-quality work at reasonable cost.  ACCEPT CLIENT AND PERFORM INITIAL AUDIT PLANNING Initial audit planning involves four things, all of which should be done early in the audit: 1. The auditor decides whether to accept a new client or continue serving an existing one. This determination is typically made by an experienced auditor who is in a position to make important decisions. The auditor wants to make this decision early, before incurring any significant costs that cannot be recovered. 2. The auditor identifies why the client wants or needs an audit. This information is likely to affect the remaining parts of the planning process. 3. To avoid misunderstandings, the auditor obtains an understanding with the client about the terms of the engagement. 4. The auditor develops an overall strategy for the audit, including engagement staffing and any required audit specialists.  Understand the client’s business and industry The nature of the client’s business and industry affects client business risk and the risk of material misstatements in the financial statements. (Client business risk is the risk that the client will fail to meet its objectives. It is discussed later in this chapter.) In recent years, several factors have increased the importance of understanding the client’s business and industry: Recent significant declines in economic conditions around the world are likely to significantly increase a client’s business risks. Auditors need to understand the nature of the client’s business to understand the impact of major economic downturns on the client’s financial statements and ability to continue as a going concern. Information technology connects client companies with major customers and suppliers. As a result, auditors need greater knowledge about major customers and suppliers and related risks. Clients have expanded operations globally, often through joint ventures or strategic alliances. Information technology affects internal client processes, improving the quality and timeliness of accounting information. The increased importance of human capital and other intangible assets has increased accounting complexity and the importance of management judgments and estimates The auditor identifies and assesses risks of material misstatement, whether due to fraud or error, based on an understanding of the entity and its environment, including the entity’s internal control The three primary reasons for obtaining a good understanding of the client’s industry and external environment are: 1. Risks associated with specific industries may affect the auditor’s assessment of client business risk and acceptable audit risk—and may even influence auditors against accepting engagements in riskier industries, such as the financial services and health insurance industries. 2. Many inherent risks are common to all clients in certain industries. Familiarity with those risks aids the auditor in assessing their relevance to the client. Examples include potential inventory obsolescence in the fashion clothing industry, accounts receivable collection inherent risk in the consumer loan industry, and reserve for loss inherent risk in the casualty insurance industry. 3. Many industries have unique accounting requirements that the auditor must understand to evaluate whether the client’s financial statements are in accordance with accounting standards. For example, if the auditor is doing an audit of a city government, the auditor must understand governmental accounting and auditing requirements. Unique accounting requirements exist for construction companies, railroads, not-for-profit organizations, financial institutions, and many other organizations. Many auditor litigation cases (like those described in Chapter 5) result from the auditor’s failure to fully understand the nature of transactions in the client’s industry similar to what occurred in the Enron case discussed in the opening vignette to this chapter. The auditor must also understand the client’s external environment, including such things as wide volatility in economic conditions, extent of competition, and regulatory requirements. For example, auditors of utility companies need more than an understanding of the industry’s unique regulatory accounting requirements. Chapter Seven (7)  Audit Documentation Auditing standards state that audit documentation is the record of the audit procedures performed, relevant audit evidence, and conclusions the auditor reached. Audit documentation should include all the information the auditor considers necessary to adequately conduct the audit and to provide support for the audit report. Audit documentation may also be referred to as working papers or workpapers, although audit documentation is often maintained in computerized files.  Purposes of Audit Documentation The overall objective of audit documentation is to aid the auditor in providing reasonable assurance that an adequate audit was conducted in accordance with auditing standards. More specifically, audit documentation, as it pertains to the current year’s audit, provides: 1. A basis for planning the audit 2. A record of the evidence accumulated and the results of the tests 3. Data for determining the proper types of audit report 4. A basis for review by supervisors and partners  Ownership of Audit Files Audit documentation prepared during the engagement, including schedules prepared by the client for the auditor, is the property of the auditor. The only time anyone else, including the client, has a legal right to examine the files is when they are subpoenaed by a court as legal evidence. At the completion of the engagement, audit files are retained on the CPA’s premises for future reference and to comply with auditing standards related to document retention.  Confidentiality of Audit Files The need to maintain a confidential relationship with the client is expressed in Rule 301 of the Code of Professional Conduct, which states: A member shall not disclose any confidential information obtained in the course of a professional engagement except with the consent of the client. During the course of the audit, auditors obtain a considerable amount of information of a confidential nature, including officers’ salaries, product pricing and advertising plans, and product cost data. If auditors divulged this information to outsiders or to client employees who have been denied access, their relationship with management would be seriously strained.  Preparation of Audit Documentation The documentation should be prepared in sufficient detail to provide an experienced auditor with no connection to the audit a clear understanding of the work performed, the evidence obtained and its source, and the conclusions reached. Although the design depends on the objectives involved, audit documentation should possess certain characteristics: Each audit file should be properly identified with such information as the client’s name, the period covered, a description of the contents, the initials of the preparer, the date of preparation, and an index code. Audit documentation should be indexed and cross-referenced to aid in organizing and filing. One type of indexing is illustrated in Figure 7-3 (p. 192). Completed audit documentation must clearly indicate the audit work performed. This is accomplished in three ways: by a written statement in the form of a memorandum, by initialing the audit procedures in the audit program, and by notations directly on the schedules. Notations on schedules are accomplished by the use of tick marks, which are symbols adjacent to the detail on the body of the schedule. These notations must be clearly explained at the bottom of the schedule.  Preparation of Audit Documentation Audit documentation should include sufficient information to fulfill the objectives for which it was designed. To properly prepare audit documentation, the auditor must know his or her goals. For example, if a schedule is designed to list the detail and show the verification of support of a balance sheet account, such as prepaid insurance, it is essential that the detail on the schedule reconciles with the trial balance. The conclusions that were reached about the segment of the audit under consideration should be plainly stated.  Permanent Files Permanent files contain data of a historical or continuing nature pertinent to the current audit. These files provide a convenient source of information about the audit that is of continuing interest from year to year. The permanent files typically include the following: Extracts or copies of such company documents of continuing importance as the articles of incorporation, bylaws, bond indentures, and contracts. The contracts may include pension plans, leases, stock options, and so on. Analyses from previous years of accounts that have continuing importance to the auditor. These include accounts such as long-term debt, stockholders’ equity accounts, goodwill, and fixed assets. Information related to understanding internal control and assessing control risk. This includes organization charts, flowcharts, questionnaires, and other internal control information, including identification of controls and deficiencies in the system. The results of analytical procedures from previous years’ audits. Among these data are ratios and percentages computed by the auditor and the total balance or the balance by month for selected accounts. This information is useful in helping the auditor decide whether there are unusual changes in the current year’s account balances that should be investigated more extensively  Current Files The current files include all audit documentation applicable to the year under audit. There is one set of permanent files for the client and a set of current files for each year’s audit. The following are types of information often included in the current file: Audit Program - Auditing standards require a written audit program for every audit. The audit program is ordinarily maintained in a separate file to improve the coordination and integration of all parts of the audit, although some firms also include a copy of the audit program with each audit section’s audit documentation. As the audit progresses, each auditor initials or electronically signs the program for the audit procedures performed and indicates the date of completion. General Information - Some audit files include current period information of a general nature rather than evidence designed to support specific financial statement amounts. This includes such items as audit planning memos, abstracts or copies of minutes of the board of directors meetings, abstracts of contracts or agreements not included in the permanent files, notes on discussions with the client, supervisors’ review comments, and general conclusions.  Current Files Working Trial Balance - Because the basis for preparing the financial statements is the general ledger, the amounts included in that record are the focal point of the audit. As early as possible after the balance sheet date, the auditor obtains or prepares a listing of the general ledger accounts and their year-end balances. This schedule is the working trial balance. Software programs enable the auditor to download the client’s ending general ledger balances into a working trial balance file.  Adjusting and Reclassification Entries Adjusting and Reclassification Entries - When the auditor discovers material misstatements in the accounting records, the financial statements must be corrected. For example, if the client failed to properly reduce inventory for obsolete raw materials, the auditor can propose an adjusting entry to reflect the realizable value of the inventory. Even though adjusting entries discovered in the audit are often prepared by the auditor, they must be approved by the client because management has primary responsibility for the fair presentation of the statements. Reclassification entries are frequently made in the statements to present accounting information properly, even when the general ledger balances are correct. A common example is the reclassification for financial statement purposes of material credit balances in accounts receivable to accounts payable. Only those adjusting and reclassification entries that significantly affect the fair presentation of financial statements must be recorded. Auditors decide when a misstatement should be adjusted based on materiality. At the same time, auditors must keep in mind that several immaterial misstatements that are not adjusted could, when combined, result in a material overall misstatement.  Supporting Schedules Supporting Schedules - The largest portion of audit documentation includes the detailed supporting schedules prepared by the client or the auditors in support of specific amounts on the financial statements. Auditors must choose the proper type of schedule for a given aspect of the audit in order to document the adequacy of the audit and to fulfill the other objectives of audit documentation. Here are the major types of supporting schedules: Analysis Trial balance or list. Reconciliation of amounts. Tests of reasonableness. Summary of procedures. Examination of supporting documents. Informational. Outside documentation.