Audit Evidence and Documentation

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The Third Standard of Field Work

Sufficient appropriate evidential matter is to obtained by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit.

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Management Assertions Embodied in the Financial Statements

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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.

Relationship of Financial Statement Assertions and the Audit

Financial Statements (GAAP)

Management Assertions

Audit Objectives

Audit Procedures

Audit Evidence

Audit Report on Financial Statements

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Audit Risk

Audit Risk =

Risk of Material Misstatement

Risk that the Auditors Fail to Detect the Misstatement

Inherent Risk

Control Risk

Detection Risk

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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

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Control Risk
Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the companys internal control.

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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

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Audit Risk Formula

AR = IR x CR x DR
AR IR CR DR = = = = Audit risk Inherent risk Control risk Detection risk

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Illustration of Audit Risk

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Audit Risk Formula Solving for Detection Risk

AR DR IR CR

Implications
Assuming constant, sufficiently low AR, detection risk is inversely related to IR and CR

combined IR and CR allowed DR substantive evidence

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

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

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Types of Evidence Physical Evidence

Evidence that can actually be seen by auditors.

This type of evidence is generally effective for supporting the existence assertion.

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Types of Evidence Third Party Representations

Confirmations Lawyers Letters Reports of Specialists

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Types of Evidence Documentary 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

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Types of Evidence Computations

Computations are: performed independently by auditor used to verify mathematical accuracy of clients analyses and records

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Types of Evidence Data Interrelationships

Data interrelationships (i.e., analytical procedures) rely on plausible relationships among financial and nonfinancial data.

Effective for testing reasonableness of certain account balances

Can be used as primary or corroborating evidence, depending on the nature of account

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Oral and Written Client Representations

Types of Evidence

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.

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Types of Evidence Accounting Records

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

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Audit Procedures

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

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.

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Reliability of Certain Types of Audit Evidence

RELIABILITY High TYPE Physical Documentary External External/Internal Internal Low Client Representations EXAMPLE Inventory Observation

Cutoff Bank Statement Purchase Invoice Sales Invoice

Management Representation Letter

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Basic Approaches to Auditing Accounting Estimates

Review and test managements process for developing the estimate. Independently develop an estimate to compare to managements estimate. Review subsequent events or transactions bearing on the estimate.

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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

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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

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Types of Working Files

Current files
Typically arranged and indexed around accounts in clients financial statement Support current years 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.

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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.

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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

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