TOPIC 6: AUDIT EVIDENCE AND SAMPLING

6.1 Audit sampling

a) Considerations and process of designing audit samples

ISA 530: Audit Sampling defines audit sampling as ‘the application of audit procedures to less than 100% of
items within a population of audit relevance such that all sampling units have a chance of selection in order
to provide the auditor with a reasonable basis on which to draw conclusions about the entire population.’

This implies that the auditor is not expected to carry out 100% test or application of procedures to all
transactions of the entity under audit. Although audit sampling is used in many situations, it is more
applicable to tests of detailed transactions as compared to tests of controls.

Sampling offers an opportunity to the auditor to reduce on transactions to be audited to an acceptable level
and is also used at the review stage while reviewing working papers.

While choosing the sample, the auditor should ensure that the sample selected is representative of the
population.

b) Determination of sample sizes and selection of items for sampling; bases/approaches to

selecting samples (statistical, non -statistical)

ISA 530 recognizes that there are many methods of selecting a sample, but it considers five principal
methods of audit sampling as follows:

• Random selection.
• Systematic selection.
• Monetary unit sampling.
• Haphazard selection.
• Block selection.

The auditor will be in position to use available tools and experience to determine the method to be used for
sampling. The objective of the test will equally contribute to the method to be used for sampling.

We shall review each item as described by ISA 530.

Random selection: This method of sampling ensures that all items within a population stand an equal
chance of selection by the use of random number tables or random number generators. The sampling units
could be physical items. Examples could be physical items within the inventory, documents like payment
vouchers or salary adjustment vouchers, or it could be monetary units like amounts paid out for t- during a
given period to each individual employee.

Systematic selection: The method divides the number of sampling units within a population into the
sample size to generate a sampling interval

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Monetary unit sampling: The method of sampling is a value weighted selection whereby sample size,
selection and evaluation will result in a conclusion in monetary amounts. The objective of monetary unit
sampling (MUS) is to determine the accuracy of financial balances and reflected in the financial statements
or account schedules.

The auditor will follow the following steps while determining MUS samples on which to perform the audit
procedures:

• Determine a sample size.

• Select the sample perform the audit procedures.
• Evaluate the results before arriving at a conclusion.
• Make conclusion about the population.

MUS is based on attribute sampling techniques and is often used in tests of controls and appropriate when
each sample can be placed into one of two classifications — exception’ or no exception’.

In developing an attribute sampling plan, the auditor must first define the audit test objective, population
involved, sampling unit, and control items to be tested.

Haphazard sampling: When the auditor uses this method of sampling, he does so without following a
structured technique. ISA 530 also recognises that this method of sampling is not appropriate when using
statistical sampling. This method cannot ensure that all items in the sample have an equal chance of being
selected. Evidence gathered from this method of sampling may not have a solid criterion for support as
there will be no criteria on which the auditor based to select the items.

Block selection: This method of sampling involves selecting a block (or blocks) of contiguous items from
within a population. An auditor may select a block items like payments made to staff between (UShs 10,000
to 50,000). When this method of selection is made, the auditor will have no further reference beyond the
period of block items selected. The auditor will be safe selecting many blocks so as to avoid the sampling
risk.

Statistical versus non-statistical sampling

ISA 530 defines both statistical sampling as an approach to sampling that has the following characteristics:

• Random selection of the sample items.

• The use of probability theory to evaluate sample results, including measurement of sampling risk.

The standard classifies non-statistical sampling as the approach that does not possess the characteristics
above.

Statistical sampling methods therefore include the following: Random sampling, Systematic sampling and
monetary unit sampling.

Non-statistical sampling methods include the following: Haphazard sampling, Block selection, and
Judgmental sampling where the auditor uses own judgment.
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Similarities between statistical and non-statistical sampling techniques

• Require auditor’s judgment during planning, implementation and evaluation of sampling plan.
• Audit procedures will be performed on whatever sample has been selected.

The main advantage of statistical sampling as opposed to non-statistical sampling is the ability of all items
the population to have an equal chance of being selected. Statistical sampling allows each sampling unit to
stand an equal chance of selection. The use of non-statistical sampling in audit sampling leaves the
selection to the auditor’s judgment. It may not work so well where the auditor is not experienced especially
with regards to the items being selected for audit.

In conclusion, auditors should use their knowledge in determination of the method to be used for selection
of the sample that will provide audit evidence that is appropriate, sufficient and reliable. Where
circumstances allow, statistical sampling should be used as far as possible.

c) Circumstances when audit sampling is not appropriate

In most cases if the information available cannot be subject to the methods and attributes of either
statistical or non-statistical sampling, then it will not be appropriate to use sampling as a means of sample
size selection.

d) Sampling risk

Sampling risk is the risk that the auditor’s conclusions based on a sample may be different from the
conclusion if the entire population were the subject of the same audit procedure. Sampling risk may lead to
two types of errors as described by ISA 530. These errors will have different effects on the auditor’s work.
They will either increase on the work to be done or an incorrect opinion being formed.

• If testing for material misstatements while using substantive testing the auditor concludes that controls
are operating effectively, when in fact they are not. The auditor may come to an overall conclusion that
there are no material misstatements. This will lead the auditor to making an incorrect opinion on the
financial statements
• The second situation is where the auditor concludes wrongly that material misstatements do exist
within the financial statements. This will lead to both an incorrect conclusion on the financial statements
as well as extra work being carried out so as to identify the material misstatements. Extra work may
lead to extra hours and costs to the client.
• Non-sampling risk is that the auditor forms the wrong conclusion which is unrelated to sampling risk.

6.2. Audit evidence

Audit evidence refers to all the information gathered by the auditor in assisting him come up with the audit
opinion. ISA 500 defines audit evidence as information used by the auditor in arriving at the conclusions on
which the auditor’s opinion is based. Audit evidence includes both information contained in the accounting
records underlying the financial statements and other information. The basic techniques in obtaining audit
evidence are not very different from the procedures used in gathering audit evidence. These have been

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discussed in topic 3 under major procedures required in undertaking an audit. Reference should be made
from that topic for the basic techniques of obtaining audit evidence.

a) Types of audit evidence

The different types of audit evidence can be classified as being:

• physical evidence;
• oral evidence;
• documentary evidence: and
• confirmations (third party representations).

The different types of audit evidence have been explained below;

Physical evidence: This includes the auditors’ direct observation and inspection of people and procedures
and or property. Examples of physical evidence may include, photographs, maps and charts. Physical
evidence may be more persuasive. It is advised that at least two auditors should be available when taking
any form of physical evidence.

Each type of evidence will have an assertion or various assertions that it may prove. For example, physical
evidence may confirm the existence of an asset but not the valuation.

Oral evidence: This information obtained by interviewing different people within the entity or beyond, who
know well enough the conditions and other specific issues that have developed audited transactions and
operations, is widely used as primary evidence in auditing. Oral evidence may also be referred to as
testimonial evidence.

This form of evidence may provide evidence about certain conditions and direction of the audit. It may be
obtained from interviews with senior management or other staff. This form of evidence should be supported
with other forms of evidence where possible as it may not be conclusive enough. ISA 330 requires the
auditor to apply professional scepticism in his/her response to assessed risks during inquiries of
management and employees.

Documentary evidence: Documentary evidence has traditionally been defined as paper based information
and recently this definition has been refined to include any type of recorded information such as a computer
or video or audio. This evidence exists in some permanent form. This is the most common form of audit
evidence gathered by auditors. Documentary evidence may be internal or external.

Examples of external audit evidence will include:

• Replies to confirmation requests.
• Invoices from suppliers and public information held by government body like titles, and other real estate
records, etc.

Examples of internal documentary evidence includes the following:

• Accounting records.

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• Receiving reports.
• Purchase orders.
• Supporting schedules like depreciation, etc.

In establishing the reliability and credibility of documentary evidence the auditor is guided by ISA 500 which
states, that “documents that have not passed through the client’s organisation are usually considered the
most reliable ones, followed by those created outside that are in the possession of the client. However,
those that were prepared inside the client’s entity are considered the least reliable ones”. The degree of
credibility of this type is dependent on the independence and objectivity of the documents and the
effectiveness of internal controls in place. Original copies would be more reliable than photocopies of the
same document.

Confirmations: This is a form of audit evidence obtained directly from third parties such a customers,
banks and other business partners with regards to a giver assertion. Confirmations will consist of written
statements arising from a request by the auditor about a given item. This may be a request to the third
party to confirm a given balance either receivable by the client or to the bank confirming the bank balance
at a given date.

Written confirmations may take several forms such as positive and negative with each having own
advantages and disadvantages. Just like other forms of audit evidence, confirmations will not confirm all
assertions. Example is that confirmations can confirm existence of a debt but will not guarantee or confirm
that the given debt or balance is recoverable.

Analytical procedures: This is evidence obtained as a result of interrelationships between the data
gathered. For internal controls, it is the inter relationships between the particular policies and procedures of
which it is composed.

International Standard on Auditing (ISA) 520 defines analytical procedures as “evaluations of financial
information through analysis of plausible relationships among both financial and non-financial data.”
Analytical procedures also include investigating the fluctuations that are not consistent with other relevant
information or that deviate from expected values. The main purpose of substantive analytical procedures is
to obtain assurance that accounts are fairly stated, detect fraud and error in transactions and account
balances, and provide evidence about audit objectives

The auditor should review the plausible relationships within the information obtained and apply audit
procedures on the information gathered as audit evidence.

b) Sources of audit evidence

Audit evidence is supposed to be sufficient and appropriate. The strength of reliability and appropriateness
of audit evidence will depend on the source where the audit evidence has been obtained.

Audit evidence is mainly from three major sources categorized as either internal or external.

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i) Internal audit evidence

Internal audit evidence is that form evidence which is obtained from within the company. Internal audit
evidence could include the following:

• Payment vouchers and invoices.

• Inventory count sheets carried out by staff.
• Prepared cashbooks and reconciliations performed by staff.

This is referred to as internally generated because it is originated from the entity under audit and the entity
has control over the evidence.

ii) External audit evidence

This is audit evidence generated from sources outside the audit entity. The audit entity has no control over
this form of evidence. Examples of external audit evidence includes the following:

• Confirmation from external parties.

• Bank statements provided by the Bank with regards to banking details of an entity.
• Reports from external consultants and experts.

iii) Self-generated audit evidence

This is evidence generated by the auditor from records and interviews or other form of procedure used by
the auditor to gather the evidence. Examples include:

• interviews and inquiries made by the auditor; and

• analytical reviews and comparisons made:
- techniques of obtaining audit evidence;
- sufficiency and appropriateness; and
- reliability.

c) Techniques of obtaining audit evidence

Techniques of obtaining audit evidence are the various means that the auditor employs to obtain sufficient
and appropriate audit evidence that will support their opinion. These techniques include the following:

Inspection: This is where the auditor examines records and or documents of the client. The documents
may be from within or external to the organisation. Reliability of this evidence will depend on the source of
evidence and the objective of the test being carried out. It should be noted that inspection of the documents
may provide evidence about existence but may not provide evidence about rights and obligations.

Observation: This is method of gathering audit evidence by looking at the process or at a process or
procedure being performed by others so that evidence about the actual performance is obtained. This
technique will provide audit evidence pertaining to the time when the observation was made. It is limited at

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that particular time and may change after the auditor has left. Example could be attendance at a cash and
inventory count at end of year or looking at the procedures being carried out during a bank reconciliation
process.

External confirmations: This is evidence obtained from external parties in response to what the auditor
has asked about. External confirmation is audit evidence that is obtained as a direct written response to the
auditor from a third party (the confirming party) in paper form, electronic medium or other medium. These
are mainly used to confirm assertions relating to account balances. Examples could be receivables, cash
and bank balance balances with banks and other external parties, etc.

Re-calculation: This is a procedure that consists of checking the mathematical accuracy of documents or
records and that can be used to verify the accuracy of the recording of transactions or of the application of
accounting policies, for example by recalculating depreciation of tangible assets. Recalculation however
does not provide evidence of the accuracy of the estimated rate of depreciation charged in relation to each
class of assets.

Re-performance: This involves the independent execution by the auditor of procedures or controls that
were originally performed as part of the entity’s internal control.

Inquiry: This involves seeking both financial and non-financial audits evidence from both staff and non-staff
members. It includes interviews and as a type of audit procedure that is used extensively during the
performance of an audit in addition to other procedures. It consists of seeking both financial and
nonfinancial information of knowledgeable persons within or outside the entity. Inquiries are important as
they may provide new information to the auditor or corroborative audit evidence or, on the contrary,
information that differs.

d) Sufficiency and appropriateness

In order to form an independent opinion about the financial statements of an entity the auditor requires
sufficient and reliable audit evidence gained through the application of audit procedures and other means.

Audit procedures used to obtain audit evidence include observation, inspection, confirmations,
recalculations and interviews among others:

In order for audit evidence to be useful in reducing to an acceptably low level the risk that the auditor could
express an inappropriate opinion when the financial statements are materially misstated and, therefore,
allow the auditor to draw reasonable conclusions, this evidence should be sufficient and appropriate to the
circumstances.

• Sufficiency relates to the measure of the quantity of audit evidence. The quantity of audit evidence
needed is affected by the risks of misstatement assessed by the auditor, whereby the higher the risks
the more audit evidence required, and by the quality of the evidence, where the higher the quality the
less evidence perhaps required. A large amount of audit evidence may, however, not compensate for
its poor quality.

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• Appropriateness relates to the quality of audit evidence. The quality of audit evidence depends on
whether it is relevant and reliable in providing support to the conclusions on which the auditor’s opinion
is based.

Factors that determine quality of audit evidence include:

 relevance of the evidence;
 consistency of the evidence; and
 timeliness of the evidence.

• Competence of the evidence, that is, the degree to which evidence can be relied upon. It is determined
by the following:
 Source of evidence.
 Is it internal or external?
 Consistence of the evidence gathered from different parties.

• Evidence obtained under good and effective internal control is more reliable than evidence obtained
under poor or ineffective internal control.
• Evidence obtained by auditors themselves is more reliable than that provided by other people.
• Evidence provided by people with proper competency and qualifications is more reliable than that
provided by people without such competency or qualifications. For example, appraisal on stock of
diamonds conducted by a jewelry expert is more reliable than an auditor’s appraisal.
• Evidence where auditors need not exercise much subjective judgment is more reliable than evidence
where such judgment is required. For example, evidence from circularization is more reliable than
inquiry evidence replies to circularization from third parties can be used directly as effective evidence
while evidence from inquiry requires auditors to conduct further analysis or even collect additional
evidence.
• Physical evidence and document evidence are more reliable than oral behavioral evidence.
• External evidence is more reliable than internal evidence.
• The independence of the person from whom the evidence is generated.
• Population evidence is more reliable than sample evidence.

In conclusion, sufficiency and appropriateness of audit evidence will depend on the techniques and
procedures applied by the audit in gathering the evidence. This will depend on the professional judgment of
the auditor. Professional judgment and experience of the auditor is, therefore, critical.

e) Reliability of audit evidence

Reliable audit evidence is the best attainable audit evidence using appropriate methods and procedures of
gathering evidence. Evidence is reliable if it can be verified by others. Reliable evidence should be valid
and accurately represent the observed facts by the auditor.

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Auditors as discussed will employ different procedures and criteria in obtaining audit evidence. Reliability of
audit evidence will depend on the following:

• Evidence obtained from reliable sources independent of the client is deemed to be more reliable than
evidence obtained from within. Examples here include confirmations of receivables or independent
expert reports. As for independent expert reports, the auditor must review the objectivity and
independence of the expert before relying on their work.
• Evidence is reliable if it can be collaborated with other audit evidence. Example could be interviews
from staff being collaborated with the figures obtained through analytical procedures.
• Evidence obtained by the auditor directly is more reliable than evidence obtained from third parties.
Example could be computations made by the auditor himself, observations of procedures and
attendance of stock taking exercise by the auditors would be more reliable than figures just provided.
• Original documents will be more reliable than copies of documents.

In conclusion, reliability of audit evidence will depend on the source and method used to generate such
evidence. The auditor is required to consider the reliability of audit evidence before concluding on whether
there are any material misstatements within the financial statements.

f) Limitations on the quality and quantity

The concepts of sufficient (quantity) and appropriate (quality) in relation to evidence are interrelated.

Auditors use professional judgment and exercise professional skepticism to determine the quantity and
quality of audit evidence

Ordinarily, auditors find it necessary to rely on audit evidence that is persuasive rather than conclusive. In
gathering and evaluating audit evidence, auditors cannot be satisfied with audit evidence that is less than
persuasive.

The quantity of evidence is sufficient if, when taken as a whole, its weight is adequate to provide
persuasive support for the contents of the assurance engagement report. For evidence to be appropriate,
the information must be relevant, reliable, and valid. In exercising professional judgment, auditors should
ask themselves whether the collective weight of the evidence that exists would be enough to persuade a
reasonable person that the observations and conclusions are valid, and that the recommendations are
appropriate. Important factors to consider in making these judgments include:

• the quality of the evidence (its relevance, reliability, and validity);

• the level of materiality (in shillings) or the significance of the observation or conclusion (in general, the
higher the level of significance or materiality, the higher the standard that evidence will have to meet);
• whether an audit level of assurance (high) or a review level of assurance (moderate) is required (for
example, a higher level of assurance is required for evidence to support observations than is required
to support contextual information included in the report);
• the risk involved in making an incorrect observation or reaching an invalid conclusion (for example, if
any risk of legal action against the auditee results from reporting an observation, the standard of
evidence demanded will be high); and

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• the cost of obtaining additional evidence relative to likely benefits in terms of supporting observations
and conclusions
We use one or more types of audit procedures to obtain audit evidence. When selecting audit procedures,
it is reasonable to take into account the relationship between the cost of obtaining the audit evidence and
the usefulness of the information obtained. Consequently, in forming the assurance engagement opinion
and/or report, auditors are generally not required to examine all the information available because they can
ordinarily reach conclusions using sampling and other means of selecting items for testing.

Appropriateness (Quality) of audit evidence may be assessed using the following criteria:

• Documentary evidence is usually better than testimonial evidence.

• Audit evidence is more reliable when the auditor obtains consistent evidence from different sources or
of a different nature (e.g., testimonial evidence is corroborated by other sources is better than
testimonial evidence alone).
• Receiving and reviewing an original document is better than receiving photocopy.
• Evidence from credible third parties may be better than evidence generates within the audited
organisation.
• The quality of information generated by the audited organisation is directly related to the strength of the
organization’s internal controls (the auditors should have a good understanding of internal controls as
they relate to the objectives of the audit).
• Evidence generated through the auditor’s direct observation, inspection, and computation is usually
better than evidence obtained indirectly.

Therefore, the quality and quantity of audit evidence gathered will be lifted by a number of factors including
the following, among others:

• Cost of gathering audit evidence.

• The auditor gathers evidence on a test basis (the sample may or may not be representative).
• People make mistakes - both client and auditor.
• Documents could be forged- increasingly easily with digital technology.
• The client’s personnel may not always tell the truth.

g) Consistency of audit evidence

i) Meaning and usefulness

Consistency of audit evidence simply means that audit evidence obtained from various sources with
regards to a subject matter is applicable and comparable to give the same conclusion about that subject
matter. It is very critical that the auditor obtains audit evidence that is consistent to enable them form an
opinion about the subject matter under audit.

If audit evidence obtained from one source is inconsistent with that obtained from another, or if the auditor
has doubts about the reliability of information to be used as audit evidence, the auditor should perform the
audit procedures necessary to resolve the matter and should determine the effect, if any, on other aspects
of the audit.
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ii) Need for consistency of audit evidence
Consistence in audit evidence is required so as to enable the auditor and any other person form the same
opinion with regards to the subject matter.

iii) Procedures used in obtaining consistent audit evidence

Audit procedures that enable the auditor obtain consistent audit evidence include the following;

• Risk assessment procedures: 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 relevant
assertion levels.
• Tests of controls: This involves testing of the operating effectiveness of controls in preventing or
detecting material misstatements at the relevant assertion level.
• Substantive procedures: Includes tests of details of classes of transactions and substantive analytical
procedures to detect material misstatements at the relevant assertion level

h) Procedures / methods / techniques of obtaining evidence

Auditors are required to obtain audit evidence that is sufficient and appropriate enough to identify any
material misstatements within the financial statements. In order to accomplish this, the auditor should follow
the following procedures:

• Perform risk assessment procedures including tests of controls and substantive procedures, including
tests of details and substantive analytical procedures.
• Put in place an overall audit strategy that gives the scope of work, and resources planned in terms of
human resources and otherwise as well as the timing of the engagement.
• A detailed audit plan explaining how the audit strategy will be achieved should be put in place. This
should indicate the procedures to be used to be performed in respect of specific assertions in the
financial statements and their timing. The audit evidence generated by the planned audit procedures
should be sufficient and appropriate to support and corroborate, or to contradict, the management’s
assertions in respect of specific classes of transactions, account balances or disclosures in the
financial statements.
• The nature of timing and further audit procedures should be based on the results of the initial risk
assessment procedures, like the entity’s business risk assessment or the assessment of internal
controls, performed in respect of the risks identified. Further audit procedures should respond to the
assessed risks of material misstatement at the assertion level, so that sufficient appropriate evidence
can be obtained in respect of those risks.
• Standard audit programs should then be developed giving a step by step of how the procedures on
each assertion will be carried out by the auditor.
• Audit procedures in respect of specific items in the financial statements should be designed with the
objective of providing evidence capable of verifying the assertions embodied in an item, to enable the
auditor draw a reasonable conclusion about the items being tested. Audit evidence and the auditor’s
conclusions in respect of the various assertions tested contribute to the overall audit evidence on which
the auditor’s opinion is based.
The audit evidence obtained should be able to meet the assertions detailed in topic 3.

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6.3 Analytical procedures

a) Definition of analytical procedures

“Analytical procedures” means the analysis of significant ratios and trends including the resulting
investigation of fluctuations and relationships that are inconsistent with other relevant information or deviate
from predicted amounts.

Analytical procedures include the consideration of comparisons of the entities.

Financial information with, for example:

• comparable information for prior periods;
• anticipated results of the entity, such as budgets or forecasts
• expectations of the auditor, such as an estimation of depreciation; or
• similar industry information, for example, a comparison of the entity’s ratio of sales accounts receivable
with industry averages.

Analytical procedures also include consideration of relationships:

• among elements of financial information that would be expected to conform to a predictable pattern
based on the entity’s experience such as gross margin percentages;
• between financial information and relevant non-financial information such as payroll costs to number of
employees; and
• Comparison of financial information from consolidated and related entities.

The auditor may use various methods to carry out the substantive procedures mentioned above. These
may be from making simple to complex analysis of financial and non-financial information. The choice of
the techniques to use will depend on the auditor’s requirement, level of materiality and the objective to be
achieved.

Types of analytical procedures:

Analytical procedures could include though not limited to the following;

• Trend analysis (e.g., graphical time series and regression analysis);

• Ratio analysis; and
• Reasonableness tests (also called ‘proof in total’).

Trend analysis

Trend analysis compares current data with prior periods and is particularly useful for analyzing income and
expenditure (e.g., monthly turnover). Methods include:

• ‘scatter graphs’ and other graphical techniques which rely on visual inspection;
• time-series analysis which isolates trends from data by removing seasons fluctuations; and
• statistical regression (e.g., calculating the ‘line of best fit’) using a computer programme.
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Ratio analysis

Useful ratios include:

• financial ratios such as the receivables collection period (i.e. debtor days) and inventory (i.e. stock)
turnover ratios; and
• ratios which relate account balances to another account balance (e.g. expense accounts as a
percentage of sales revenue).

Because ratios identify stable relationships they tend to be more relevant than absolute changes which
could be influenced by many factors. Comparisons can be made with prior periods and against budgets
and industry statistics.

Ratios may be used more in planning (see above) and review (see below) than in obtaining substantive
evidence.

Reasonable tests

These provide an independent check on the total value of a population and are most useful for income and
expenditure accounts. The mechanics are:

• Calculate the expected value of a population. Base data must be independent of the population being
tested (or otherwise confirmed to be materially correct).
• Compare with recorded value.
• Difference should not be material.

Such proofs in total’ may remove the need for further substantive procedures (i.e. tests of detail).

b) Use of substantive analytical procedures in an audit

Analytical procedures are used for the following purposes:

• To assist the auditor in planning the nature, timing and extent of other audit procedures.
• As substantive procedures when their use can be more effective or efficient than tests of details in
reducing detection risk for Specific financial statement assertions.
• As an overall review of the financial statements in the final review stage of the audit.

The auditor is more likely to use analytical procedures:

• for existing well-established clients; in well-known, stable industries;

• where predictive information is readily available; and
• where accounting and internal control systems are effective.

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Analytical procedures in planning the audit

Analytical procedures at this stage (sometimes called ‘preliminary analytical review’) assist in:

• increasing knowledge and understanding of the business through the accumulation of information on
trends in key relationships;
• identifying areas of potential risk (e.g., relating to the enterprise’s financial condition); and
• determining the nature, timing and extent of other audit procedures (i.e. audit strategy) by directing
tests to areas of potentially material misstatement.

Ratio analysis (i.e., the comparison of relationships between account balances and classes of transactions
over several accounting periods) is particularly useful in identifying fluctuations for investigation. Because of
the inter-dependency of many ratios, breaking them down and further refinement into specific components
will identify the source of individual fluctuations.

For example, breaking down return on capital employed (ROCE) into gross profit on sales and asset
turnover, then inventory turnover, average debt collection period, etc.

The auditor should apply analytical procedures at the planning stage to assist in understanding the
business and in identifying areas of potential risk.

Application of analytical procedures may indicate aspects of the business of which the auditor was unaware
and will assist in determining the nature, timing and extent of other audit procedures.

Analytical procedures in planning the audit use both financial and non-financial information, for example,
the relationship between sales and square footage of selling space or volume of goods sold.

Stages other than planning

Substantive analytical procedures at stages other than the planning and overall review stages are optional.
Substantive analytical procedures (SAPs) are based on the expectation that relationships which are known
to exist may be expected to continue in the absence of clear evidence to the contrary. For example, the
relationship between gross profit and sales revenue may be expected to remain constant unless there are
changes in sales prices, sales mix and/or cost structure.

Analytical procedures can themselves provide sufficient audit evidence where an item can be verified
directly by reference to another (valid) item. For example, commission on sales, bank interest receivable (or
payable), rental income (or expense) and depreciation charges. (See proof in total later.)

Analytical procedures may also be effective in testing for understatement (i.e. completeness). For example,
in predicting sales from purchases and known margins. Sometimes overall reconciliations between unit
sales, purchases and inventory may be the only satisfactory way to test for completeness.

However, where sufficient substantive evidence is not obtained by analytical procedures alone, some tests
of detail will also be required. Note that tests of control at this stage of the audit would be inappropriate.

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Analytical review at the overall review stage

Analytical review at this stage is required in forming an overall conclusion as to whether the financial
statements are consistent with the auditor’s knowledge of the business. The review may also identify the
need for further substantive procedures.

Ratio analysis is particularly useful in testing the consistency of the interrelationships of amounts disclosed
in the financial statements. It is usual to compare ratios calculated at this stage with those of the preliminary
analytical review.

Factors determining the extent of use of substantive analytical procedures

• The closeness of relationships between items of data. Analytical procedures are more appropriate
when relationships are plausible and predictable (e.g., between sales commission and sales revenue).
A plausible relationship is one which may reasonably be expected to exist.
• Audit objectives and the extent to which the results of analytical procedures are reliable.
• The degree of disaggregation in available information. For example, a detailed review of gross profit
margins by major product would be more effective than the review of an overall gross profit.
• The availability and reliability of financial data (e.g., budgets) and nonfinancial data (e.g., units
produced). Independently prepared non-financial data should facilitate more effective procedures.
• The relevance of available information. For example, budgets based on expectation are more useful
than targets.
• The comparability of available information. For example, summary statistics, such as the Retail Price
Index (RPI) may not be relevant in technologically advanced industries.
• The auditor’s cumulative knowledge and experience. Effective analytical procedures are based on
recognising unusual or unexpected a knowledge is limited, it is difficult to know what to expect.
• The nature of the enterprise and its operations. When steady trends develop, it is easier to know what
to expect and identify variations.

Factors determining the extent of reliance on substantive analytical procedures

• The risk that analytical procedures fail to identify a material misstatement. This is inter-linked with the
materiality of items involved. The less significant and account balance or class of transactions, the
more reliance may be placed on analytical procedures.
• Other audit procedures directed to the same financial statement assertion For example, a reduction in
the extent of tests of detail will be justified where significant fluctuations and inconsistencies have been
corroborated.
• The accuracy of predictions. Statement of Comprehensive Income (Income and expenditure) accounts
tend to be more predictable than Statement of Financial Position (balance sheet) accounts because
they are composed of large numbers of like transactions (whereas balances tend to be a net amount).
Non-recurring accounting entries (e.g., asset revaluations) and discretionary expenses (e.g., research
and development) do not lend themselves to effective analytical procedures.
• Risk assessments. For example, if internal control over the processing of sales orders is weak (i.e.,
control risk is high) more reliance on tests of details for drawing conclusions on receivables may be
required.
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• The effectiveness of controls, if any, over the preparation of information used for analytical procedures.
• The type of analytical procedure used (see below). The more appropriate the analytical procedure, the
more reliance can be placed thereon.

c) Explain how results of analytical procedures are investigated

The auditor’s reliance on substantive procedures to reduce detection risk relating to specific financial
statement assertions may be derived from substantive tests, analytical procedures, or from a combination
of both. The decision about which procedures to use to achieve a particular audit objective is based on the
auditor’s judgment. This is about the expected effectiveness and efficiency of the available procedures in
reducing detection risk for specific financial statement assertions. The auditor will ordinarily inquire of
management as to the availability and reliability of information needed to apply analytical procedures and
the results of any such procedures performed by the entity.

When intending to perform analytical procedures as substantive procedures, the auditor will need to
consider a number of factors such as:

• Objectives of the analytical procedures, and the extent to which their results can be relied upon.
• Nature of the entity and the degree to which information can be disaggregated, for example, analytical
procedures may be more effective when applied to financial information on individual sections than
when applied to the financial statements of the entity.
• Availability of information, both financial, such as budgets or forecasts and non-financial, such as the
number of units produced or sold.

6.4. External confirmations

External confirmations are referred as audit evidence obtained by the auditor in form of a direct written
response from a third party. External confirmations are usually used as audit procedures to confirm
existence receivables, bank balances, liabilities and inventory, among others.

a) Importance of external confirmations

Per ISA 505, reliability of audit evidence is influenced by its source External audit evidence will be more
reliable than audit evidence obtained from internal sources.

b) How external confirmations are performed

External confirmations will be carried out through the following:

• Making telephone calls to the respondent to corroborate the information provided in the response.
• Making telephone calls to the respondent’s supervisor to corroborate the respondent’s independence,
knowledge of the matter, and authority to respond.
• Sending confirmation requests at interim and period end dates, and reconciling movements in the
relevant account balances using the clients’ records and any other relevant information that may be
available.

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