Class Handouts 2018

compiled BY: ali sajjad

Audit Evidence and Management Assertions

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 1. The Concept of Audit Evidence
Audit evidence is all the information used by the auditor in arriving at the conclusions on which
the audit opinion is based, and includes the information contained in the accounting records
underlying the financial statements and other information.
1. The nature of audit evidence.
2. The sufficiency and appropriateness of audit evidence.
3. The evaluation of audit evidence.

1. The Evidence is the information gathered or used by the auditor to support

Nature of his or her opinion. The nature of the evidence refers to the form or type
Audit
of information, which include accounting records and other available
Evidence
information. Accountingrecords include the records of initial entries and
supporting records, such as checks and records of electronic fund
transfers; invoices; contracts; the general and subsidiary ledgers, journal
entries, and other adjustments to the financial statements that are not
reflected in formal journal entries; and records such as work sheets and
spreadsheets supporting cost allocations, computations, reconciliations,
and disclosures.
Many times the entries in the accounting records are initiated, recorded,
processed, and reported in electronic form. Other information that the auditor
may use as audit evidence includes minutes of meetings; confirmations from
third parties; industry analysts’ reports; comparable data about competitors
(benchmarking); controls manuals; information obtained by the auditor from
such audit procedures as inquiry, observation, and inspection; and other
informationdeveloped by, or available to, the auditor that permits the auditor to
reach conclusions through valid reasoning.

2. The Sufficiency Sufficiency is the measure of the quantity of audit evidence.

& Appropriateness is a measure of the quality of audit evidence. Sufficiency
Appropriateness
and appropriateness of audit evidence are interrelated. The auditor must
of Audit Evidence

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 consider both concepts when assessing risks and designing audit
procedures.
The quantity of audit evidence needed is affected by the risk of misstatement and by the quality
of the audit evidence gathered. Thus, the greater the risk of misstatement, the more audit
evidence is likely to be required to meet the audit test. And the higher the quality of the
evidence, the less evidence that may be required to meet the audit test. Accordingly, there is
an inverse relationship between the sufficiency and appropriateness of audit evidence.
i. Relevance The appropriateness of evidence depends on its relevance to the
assertion being tested. If the auditor relies on evidence that is unrelated to the
assertion, he or she may reach an incorrect conclusion about the assertion.
ii. Reliability The reliability or validity of evidence refers to whether a particular
type of evidence can be relied upon to signal the true state of an assertion.
Because of varied circumstances on audit engagements, it is difficult to
generalize about the reliability of various types of evidence. However, the
reliability of evidence is influenced by its source and by its nature and is
dependent on the individual circumstances under which it is obtained.
iii. Knowledgeable independent source of the evidence.Evidence obtaineddirectly
by the auditor from a knowledgeable independent source outsidethe entity is
usually viewed as more reliable than evidence obtainedsolely from within the
entity. Thus, a confirmation of the client’s bankbalance received directly by the
auditor would be viewed as more reliablethan examination of the cash receipts
journal and cash balance asrecorded in the general ledger. Additionally, evidence
that is obtainedfrom the client, but that has been subjected to verification by
aknowledgeable independent source, is viewed as more reliable thanevidence
obtained solely from within the entity. For example, a canceledcheck held by the
client would be more reliable than a duplicate copy ofthe check because the
canceled check would be endorsed by the payeeand cleared through the bank—
in other words, it has been verified by anindependent source.

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iv. Effectiveness of internal control. A major objective of a client’s internalcontrol is
to generate reliable information to assist management decisionmaking. As part
of the audit, the effectiveness of the client’s internalcontrol is assessed. When
the auditor assesses the client’s internal controlas effective (that is, low control
risk), evidence generated by thataccounting system is viewed as reliable.
Conversely, if internal control isassessed as ineffective (that is, high control risk),
the evidence from theaccounting system would not be considered reliable. Thus,
the moreeffective the client’s internal control, the more assurance it provides
aboutthe reliability of audit evidence.
v. Auditor’s direct personal knowledge.Evidence obtained directly by the auditor
(e.g., observation of the performance of a control) is generally considered to be
more reliable than evidence obtained indirectly or by inference (e.g., inquiry
about the performance of a control). For example, an auditor’s physical
inspection of a client’s inventory is considered to be relatively reliable because
the auditor has direct personal knowledge regarding the inventory. There are, of
course, exceptions to this general rule. For example, if an auditor examined an
inventory composed of diamonds or specialty computer chips, the auditor may
lack the expertise to appropriately assess the validity and valuation of such
inventory items. In such cases, the auditor may need the skill and knowledge of a
specialist to assist with the inventory audit.
vi. Documentary evidence.Audit evidence is more reliable when it exists
indocumentary form, whether paper, electronic, or other medium. Thus,
awritten record of a board of directors meeting is more reliable than
asubsequent oral representation of the matters discussed.
vii. Original documents.Audit evidence provided by original documents ismore
reliable than audit evidence provided by photocopies or facsimiles.An auditor’s
examination of an original, signed copy of a lease agreementis more reliable
than a photocopy.Determining the sufficiency and appropriateness of evidence
are two of the more critical decisions the auditor faces on an engagement.

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 3. The Evaluation The ability to evaluate evidence appropriately is another important skill
of Audit Evidence an auditor must develop. Proper evaluation of evidence requires that the
auditor understand the types of evidence that are available and their
relative reliability of diagnostic.
The auditor must be capable of assessing when a sufficient amount of
competent evidence has been obtained in order to determine the fairness of
management’sassertions.In evaluating evidence, an auditor should be
thorough in searching for evidence and unbiased in its evaluation. For
example, suppose an auditor decides to mail accounts receivable
confirmations to 50 of the largest customers of a client that has a total of
5,000 customer accounts receivable.

Audit Procedures for Obtaining Audit Evidences

In conducting audit procedures, the auditor examines various types of audit evidence.
Evidence is commonly categorized into the following types:
1. Inspection
2. Observation
3. Inquiry
4. Confirmation
5. Recalculation
6. Re-performance
7. Analytical procedures

i. Inspection Inspection consists of examining internal or external

records or documents that are in paper form, electronic form, or other media.
On most audit engagements, inspection of records or documents makes up the
bulk of the evidence gathered by the auditor. Two issues are important in
discussing inspection of records or documents: the reliability of such evidence
and its relationship to specific assertions.

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Observatio Observation consists of looking at a process or procedure being performed by
others. The actions being observed typically do not leave an audit trail that can
be tested by examining records or documents.
Examples include observation of the counting of inventories by the entity’s
personnel and observation of the performance of control activities. Observation
provides audit evidence about the performance of a process or procedure but is
limited to the point in time at which the observation takes place. It is also limited
by the fact that the client personnel may act differently when the auditor is not
observing them. Observation is usefulin helping auditors understand client
processes, but is generally not considered very reliable and thus generally
requires additional corroboration by the auditor.

Inquiry Inquiry consists of seeking information of knowledgeable persons (both financial

and nonfinancial) throughout the entity or outside the entity. Inquiry is an
important audit procedure that is used extensively throughout the audit and
often is complementary to performing other audit procedures. For example,
much of the audit work conducted to understand the entity and its environment
includinginternal control involves inquiry.

Confirmation Confirmation is a specific type of inquiry. It is the process of obtaining a

representation of information or of an existing condition directly from a
third party. Confirmations also are used to obtain audit evidence about
the absence of certain conditions, for example, the absence of a “side
agreement” that may influence revenue recognition.
Auditors usually use the term inquiry to refer to unwritten questions asked of the
client or of a third party, and the term confirmation to refer to written requests
for a written response from a third party.
The reliability of evidence obtained through confirmations is directly affected by factors
such as
 The form of the confirmation.
 Prior experience with the entity.

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  The nature of the information being confirmed.
 The intended respondent.
Recalculation consists of checking the mathematical accuracy of
Recalculation
documents or records. Recalculation can be performed through the use
of information technology(e.g., by obtaining an electronic file from the
entity and using computer-assisted audit techniques, or CAATs, to check
the accuracy of the summarization of the file).

Re-performance Re-performance is the auditor’s independent execution of procedures or

controls that were originally performed as part of the entity’s internal
control, either manually or through the use of CAATs. For example, the
auditor may re-perform the aging of accounts receivable. Again, because
the auditor creates this type of evidence, it is normally viewed as highly
reliable.
Analytical procedures are an important type of evidence on an audit.
Analytical
Procedure They consist of evaluations of financial information made by a study of
s
plausible relationships among both financial and nonfinancial data.
For example, the current-year accounts receivable balance can be compared to the
prior-years’ balances after adjusting for any increase or decrease in sales and other
economic factors. Similarly, the auditor might compare the current-year gross margin
percentage to the gross margin percentage for the previous five years. The auditor
makes such comparisons either to identify accounts that may contain material
misstatements and require more investigation or as a reasonableness test of the
account balance. Analytical procedures are an effective and efficient form of evidence.
The reliability of analytical procedures is a function of (1) the availability and reliability
of the data used in the calculations, (2) the plausibility and predictability of the
relationship being tested, and (3) the precision of the expectation and the rigor of the
investigation.

Hierarchy of Reliability of Audit Evidence

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 Level of Responsibility Types of Evidence
High Inspection
Re-performance
Recalculation
Medium Confirmation
Analytical Procedures
Low Inquiry
Observation

Reliability of the Table presents a hierarchy of the reliability of the types of

types of Evidence
evidence. Inspectionof tangible assets, Re-performance, and
recalculation are generally considered of high reliability because
the auditor has direct knowledge about them. Documentation,
scanning, confirmation, and analytical procedures are generally
considered to be of medium reliability.

2. Management Assertions
Management is responsible for the fair presentation of the financial statements.Assertions are
expressed or implied representations by management regarding the recognition, measurement,
presentation, and disclosure of information in the financial statements and related disclosures.
For example, when the balance sheet contains a line item for accounts receivable of $5 million,
management asserts that those receivables exist and have a net realizable value of $5 million.
Management also asserts that the accounts receivable balance arose from selling goods or
services on credit in the normal course of business. In general, the assertions relate to the
requirements of generally accepted accounting principles.
Under current auditing standards, management assertions fall into the following
categories:
1. Assertions about classes of transactions and events for the period
underaudit.

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 2. Assertions about account balances at the period end.
3. Assertions about presentation and disclosure.
Table given below presents the definitions of each assertion by category while shows how the
assertions are related across categories. Pay close attention to the wording of the assertions as
defined and described below. The way auditors use certain words as they relate to assertions
may differ somewhat from your everyday usage of the terms, and part of mastering auditing is
learning the language of auditors.

Definition of Management Assertions by category

Assertions about classes of transactions and events for the period under audit:

 Occurrence—transactions and events that have been recorded have occurred and pertain to the entity

(sometimes referred to as validity).

 Completeness—all transactions and events that should have been recorded have been recorded.

 Authorization—all transactions and events have been properly authorized.

 Accuracy—amounts and other data relating to recorded transactions and events have been recorded

appropriately.

 Cutoff—transactions and events have been recorded in the correct accounting period.

 Classification—transactions and events have been recorded in the proper accounts

Assertions about account balances at the period end:

 Existence—assets, liabilities, and equity interests exist.

 Rights and obligations—the entity holds or controls the rights to assets, and liabilities are the obligations of the

entity.

 Completeness—all assets, liabilities and equity interests that should have been recorded have been recorded.

 Valuation and allocation—assets, liabilities, and equity interests are included in the financial statements at

appropriate amounts, and any resulting valuation or allocation adjustments are appropriately recorded.

Assertions about presentation and disclosure:

 Occurrence and rights and obligations—disclosed events, transactions, and other matters have occurred and

pertain to the entity.

 Completeness—all disclosures that should have been included in the financial statements have been included.

 Classification and understandability—financial information is appropriately presented and described, and

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 disclosures are clearly expressed.

 Accuracy and valuation—financial and other information are disclosed fairly and at appropriate amounts.

Assertions relating to classes of transactions

Assertions Explanation Examples: Salaries & Wages Cost

Occurrence Transactions recognized in the Salaries & wages expense has been incurred
financial statements have during the period in respect of the personnel
occurred and relate to the entity. employed by the entity. Salaries and wages
expense does not include the payroll cost of
any unauthorized personnel.

Completeness All transactions that were Salaries and wages cost in respect of all
supposed to be recorded have personnel have been fully accounted for.
been recognized in the financial
statements.

Accuracy Transactions have been recorded Salaries and wages cost has been calculated
accurately at their appropriate accurately. Any adjustments such as tax
amounts. deduction at source have been correctly
reconciled and accounted for.

Cut-off Transactions have been Salaries and wages cost recognized during the
recognized in the correct period relates to the current accounting period.
accounting periods. Any accrued and prepaid expenses have been
accounted for correctly in the financial
statements.

Classification Transactions have been classified
and presented fairly in the
financial statements.
Salaries and wages cost has been fairly
allocated between:
-Operating expenses incurred in production
activities;
-General and administrative expenses; and
-Cost of personnel relating to any self-
constructed assets other than inventory.

Assertions relating to assets, liabilities and equity balances at the period end

Assertions Explanation Examples: Inventory balance

Existence Assets, liabilities and equity Inventory recognized in the balance sheet
balances exist at the period end. exists at the period end.

Completeness All assets, liabilities and equity All inventory units that should have been
balances that were supposed to recorded have been recognized in the financial
be recorded have been statements. Any inventory held by a third party
recognized in the financial on behalf of the audit entity has been included
statements. in the inventory balance.

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Rights & Entity has the right to ownership
Obligations or use of the recognized assets,
and the liabilities recognized in the
financial statements represent the
obligations of the entity.
Audit entity owns or controls the inventory
recognized in the financial statements. Any
inventory held by the audit entity on account of
another entity has not been recognized as part
of inventory of the audit entity.

Valuation Assets, liabilities and
balances have been valued
appropriately.
equity Inventory has been recognized at the lower of
cost and net realizable value in accordance
with IAS 2 Inventories. Any costs that could
not be reasonably allocated to the cost of
production (e.g. general and administrative
costs) and any abnormal wastage has been
excluded from the cost of inventory. An
acceptable valuation basis has been used to
value inventory cost at the period end
(e.g. FIFO, AVCO, etc.)

Assertions relating to presentation and disclosures

Assertions Explanation Examples: Related Party Disclosures

Occurrence Transactions and events Transactions with related parties disclosed in

disclosed in the financial the notes of financial statements have
statements have occurred and occurred during the period and relate to the
relate to the entity. audit entity.

Completeness All transactions, balances, events All related parties, related party transactions
and other matters that should and balances that should have been disclosed
have been disclosed have been have been disclosed in the notes of financial
disclosed in the financial statements.

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 statements.

Classification & Disclosed events, transactions, The nature of related party transactions,
Understandability balances and other financial balances and events has been clearly
matters have been classified disclosed in the notes of financial
appropriately and presented statements. Users of the financial
clearly in a manner that promotes statements can clearly determine the financial
the understandability of statement captions affected by the related
information contained in the party transactions and balances and can
financial statements. easily ascertain their financial effect.

Accuracy & Transactions, events, balances Related party transactions, balances and
Valuation and other financial matters have events have been disclosed accurately at their
been disclosed accurately at their appropriate amounts.
appropriate amounts.

Assertions about Assertions about classes of transactions and events relate to the
Classes of Transactions transactions thatgave rise to the ending account balances
and Events during the
Period included in the financial statements. As explained earlier,
sometimes auditors perform procedures to gather evidence about
transactions. Transaction-related assertions help the auditor
conceptualize, plan, and perform those procedures.
Occurrence The occurrence assertion relates to whether all recorded transactions and events
have occurred and pertain to the entity. For example, management asserts that all revenue
transactions recorded during the period were valid transactions. Occurrence is sometimes also
referred to as validity.
Completeness The completeness assertion relates to whether all transactions and events that
occurred during the period have been recorded. For example, if a client fails to record a valid
revenue transaction, the revenue account will be understated. Note that the auditor’s concern
with the completeness assertion is opposite the concern for occurrence. Failure to meet the
completeness assertion results in an understatement in the related account, while failure to
meet the occurrence assertion results in an overstatement in the account.
Authorization The authorization assertion relates to whether all transactions have been
properly authorized. For example, the purchase of a material amount of plant and equipment
should be approved by the board of directors.

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Accuracy The accuracy assertion addresses whether amounts and other data relating to
recorded transactions and events have been recorded appropriately. Generally accepted
accounting principles establish the appropriate method for recording a transaction or event.
For example, the amount recorded for the cost of a new machine includes its purchase price
plus all reasonable costs to install it. As another example, a sale to a customer that is recorded
at an incorrect amount due to omission of an applicable discount would be considered a valid
but inaccurate sales transaction.
Cutoff The cutoff assertion relates to whether transactions and events have been recorded in
the correct accounting period. The auditor’s procedures must ensure that transactions
occurring near year-end are recorded in the financial statements in the proper period. For
example, the auditor may want to test proper cutoff of revenue transactions at December 31,
2007. The auditor can examine a sample of shipping documents and sales invoices for a few
days before and after year-end to test whether the sales transactions are recorded in the
proper period. The objective is to determine that all 2007 sales and no 2008 saleshave been
recorded in 2007. Thus, the auditor examines the shipping documents to ensure that no 2008
sales have been recorded in 2007 and that no 2007 sales are recorded in 2008.
Classification The classification assertion is concerned with whether transactions and events
have been recorded in the proper accounts. For example, management asserts that all direct
cost transactions related to inventory have been properly classified in either inventory or as
part of cost of sales. As another example, purchases are properly recorded as either assets or
expenses, as appropriate.

Assertions about Assertions about account balances relate directly to the ending balances
Account Balances of the accountsincluded in the financial statements. Auditors sometimes
at the Period End.
perform procedures to gather evidence directly about ending account
balances. Balance-related assertions help the auditor conceptualize, plan,
and perform such procedures.
Existence The assertion about existence addresses whether ending balancesof assets, liabilities,
and equity interests included in the financial statements actually exist at the date of the

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financial statements. For example, management asserts that inventory shown on the balance
sheet exists and is available for sale.
Rights and Obligations The assertions about rights and obligations address whether the entity
holds or controls the rights to assets included on the financial statements, and that liabilities
are the obligations of the entity. For example, management asserts that the entity has legal title
or rights of ownership to the inventory shown on the balance sheet. Similarly, amounts
capitalized for leases reflect assertions that the entity has rights to leased property and that the
corresponding lease liability represents an obligation of the entity.
Completeness The assertion about completeness addresses whether all assets, liabilities, and
equity interests that should have been included as ending balances on the financial statements
have been included. For example, management implicitly asserts that the ending balance
shown for accounts payable on the balance sheet includes all suchliabilities as of the balance
sheet date.
Valuation and Allocation Assertions about valuation or allocation addresswhether assets,
liabilities, and equity interests included in the financial statements are at appropriate amounts
and any resulting valuation or allocation adjustments are appropriately recorded. For example,
management asserts that inventory is carried at the lower of cost or market value on the
balance sheet. Similarly, management asserts that the cost of property, plant, and equipment is
systematically allocated to appropriate accounting periods by recognizing depreciation
expense.

Assertion about This category of assertions relates to presentation of information

Presentation and in the financialstatements and disclosures in the footnotes that
Disclosure
are directly related to a specific transaction or account balance
(e.g., disclosure related to property and equipment) and those
that apply to the financial statements in general (e.g., the
footnote for the summary of significant accounting policies).
Occurrence and Rights and Obligations The assertions about occurrenceand rights and
obligations address whether disclosed events, transactions, and other matters have occurred
and pertain to the entity. For example, when management presents capitalized lease

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transactions on the balance sheet as leased assets, the related liabilities as long-term debt, and
the related footnote, it is asserting that a lease transaction occurred, it has a right to the leased
asset, and it owes the related lease obligation to the lessor. In addition, there is a footnote
disclosure that provides additional information on the lease such as future payments.
Completeness The completeness assertion in this category relates to whether all disclosures
that should have been included in the financial statements have been included. Therefore,
management asserts that no material disclosures have been omitted from the footnotes and
other disclosures accompanying the financial statements.
Classification and Understandability the assertions related to classification and
understandability address whether the financial information is appropriately presented and
described and disclosures are clearly expressed. For example, management asserts that the
portion of long-term debt shown as acurrent liability will mature in the current year. Similarly,
management asserts that all major restrictions on the entity resulting from debt covenants are
disclosed in footnotes and are able to be understood by the users of the financial statements.
Accuracy and Valuation The accuracy and valuation assertions address whether financial and
other information is disclosed fairly and at appropriate amounts. For example, when
management discloses the fair value of stock or bond investments, it is asserting that these
financial instruments are properly valued in accordance with GAAP. In addition management
may disclose in a footnote other information related to financial instruments. Before we discuss
important characteristics of evidence available to the auditor, pause for a moment to consider
the usefulness of the sets of management assertions we have just discussed. The assertions
collectively provide a road map for the auditor in determining what evidence to collect
regarding various transactions, account balances, and required financial statement disclosures.
They also guide the auditor in designing audit procedures to collect the needed evidence, as
well as assisting the auditor in evaluating the appropriateness and sufficiency of the evidence.
For example, once the auditor is comfortable that he or she has gathered sufficient appropriate
evidence relating to each balance-related assertion for the accounts payable account, the
auditor can rest assured that no important aspect of that account has been neglected. The
management assertions help the auditor focus his or her attention on all the various aspects of

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transactions, account balances, and required disclosures that need to be considered—they help
the auditor ensure that “all the bases are covered.” As such, the three sets of management
assertions constitute a powerful conceptual tool in the auditor’s toolbox.

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