Audit Evidence

How court cases and an audit are similar

In both a legal case and in an audit of financial statements, evidence is

used by an unbiased person to draw conclusions. In addition, the
consequences of an incorrect decision in both situations can be equally
undesirable. For example, if a guilty person is set free, society may be
in danger if the person repeats his or her illegal act. Similarly, if
investors rely on materially misstated financial statements, they could
lose significant amounts of money. Finally, the guilt of a defendant in a
legal case must be proven beyond a reasonable doubt. This is similar to
the concept of sufficient appropriate evidence in an audit situation. As
with a judge or jury, an auditor cannot be completely convinced that his
or her opinion is correct, but rather must obtain a high level of
assurance. The nature of evidence in a legal case and in an audit of
financial statements differs because a legal case relies heavily on
testimony by witnesses and other parties involved. While inquiry is a
form of evidence used by auditors, other more reliable types of evidence
such as confirmation with third parties, physical examination, and
documentation are also used extensively. A legal case also differs from
an audit because of the nature of the conclusions made. In a legal case,
a judge or jury decides the guilt or innocence of the defendant. In an
audit, the auditor issues one of several audit opinions after evaluating
the evidence.

Four major audit evidence decisions that must be made on every

audit are:

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 procedure.

Audit Program and audit procedures

An audit procedure is the detailed instruction for the collection of a type

of audit evidence that is to be obtained. Because audit procedures are
the instructions to be followed in accumulating evidence, they must be
worded carefully to make sure the instructions are clear. An audit
program for accounts receivable is a list of audit procedures that will be

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used to audit accounts receivable for a given client. The audit
procedures, sample size, items to select, and timing should be included
in the audit program. The auditor must obtain sufficient appropriate
evidence by performing audit procedures to afford a reasonable basis
for an opinion regarding the financial statements under audit. There are
three major phrases of the standard.

The 3rd standard of fieldwork (explained)

PHRASE MEANING OF PHRASE

Obtain sufficient appropriate evidence The auditor must obtain evidence that is
reliable and there must be a reasonable
quantity of that evidence.

By performing audit procedures The auditor performs audit procedures to

meet audit objectives using the eight types
of evidence.

To afford a reasonable basis for an The auditor cannot expect to be completely

opinion regarding the financial statements certain that the financial statements are
fairly presented but there must be
persuasive evidence. The collection of
evidence gathered by the auditor provides
the basis for the auditor's opinion.

There are two primary reasons why the auditor can only be
persuaded with a reasonable level of assurance, rather than be
convinced that the financial statements are correct:

1. The cost of accumulating evidence. It would be extremely

costly for the auditor to gather enough evidence to be
completely convinced.
2. Evidence is normally not sufficiently reliable to enable the
auditor to be completely convinced. For example,
confirmations from customers may come back with
erroneous information, which is the fault of the customer
rather than the client.

The two determinants of the persuasiveness of evidence are

appropriateness and sufficiency. Appropriateness refers to the relevance
and reliability of evidence, or the degree to which evidence can be
considered believable or worthy of trust. Appropriateness relates to the

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audit procedures selected, including the timing of when those
procedures are performed. Sufficiency refers to the quantity of evidence
and it is related to sample size and items to select.

Characteristics that determine reliability of evidence.

FACTOR EXAMPLE OF
DETERMINING RELIABILITY RELIABLE EVIDENCE
Independence of provider Confirmation of a bank balance

Effectiveness of client's internal controls Use of duplicate sales invoices for a large
well-run company

Physical examination of inventory by the

Auditor's direct knowledge
auditor

Qualifications of provider Letter from an attorney dealing with the

client's affairs

Degree of objectivity Count of cash on hand by auditor

Timeliness Observe inventory on the last day of the

fiscal year

Types of audit evidence and examples

EXAMPLES
TYPES OF AUDIT EVIDENCE
Count petty cash on hand
1. Physical examination
Examine fixed asset additions

Confirm accounts receivable balances of a

2. Confirmation
sample of client customers
Confirm clients cash balance with bank

Examine cancelled checks returned with cutoff

3. Documentation
bank statement
Examine vendors invoices supporting a sample of
cash disbursement transactions throughout the

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 year

Evaluate reasonableness of receivables by

4. Analytical procedures
calculating and comparing ratios
Compare expenses as a percentage of net sales
with prior years percentages

Inquire of management whether there is obsolete

5. Inquiries of the client
inventory
Inquire of management regarding the collectibility
of large accounts receivable balances
6. Recalculation Recompute invoice total by multiplying item price
times quantity sold
Foot the sales journal for a one-month period and
compare all totals to the general ledger

7. Reperformance Agree sales invoice price to approved price list

Match quantity on purchase invoice to receiving
report

8. Observation Observe client employees in the process of

counting inventory
Observe whether employees are restricted from
access to the check signing machine

The four characteristics of the definition of a confirmation are:

1. Receipt
2. Written or oral response
3. From independent third party
4. Requested by the auditor

A confirmation is prepared specifically for the auditor and comes from

an external source. External documentation is in the hands of the client
at the time of the audit and was prepared for the client's use in the day-
to-day operation of the business.

Documentation

Internal documentation is prepared and used within the client's

organization without ever going to an outside party, such as a customer
or vendor.

Examples:

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 check request form
receiving report
payroll time card
adjusting journal entry

External documentation either originated with an outside party or was

an internal document that went to an outside party and is now either in
the hands of the client or is readily accessible.

Examples:
vendor's invoice
cancelled check
cancelled note
validated deposit slip

Analytical procedures are useful for indicating account balances that

may be distorted by unusual or significant transactions and that should
be intensively investigated. They are also useful in reviewing accounts
or transactions for reasonableness to corroborate tentative conclusions
reached on the basis of other evidence. The most important reasons for
performing analytical procedures are the following:

1. Understanding the client's industry and business

2. Assessment of the entity's ability to continue as a going
concern
3. Indication of the presence of possible misstatements in the
financial statements
4. Reduction of detailed audit tests

Attention directing analytical procedures occur when significant,

unexpected differences are found between current year's unaudited
financial data and other data used in comparisons. If an unusual
difference is large, the auditor must determine the reason for it, and
satisfy himself or herself that the cause is a valid economic event and
not an error or misstatement due to fraud. When an analytical procedure
reveals no unusual fluctuations, the implication is minimized. In that
case, the analytical procedure constitutes substantive evidence in
support of the fair statement of the related account balances, and it is
possible to perform fewer detailed substantive tests in connection with
those accounts. Frequently, the same analytical procedures can be
used for attention directing and for reducing substantive tests,

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depending on the outcome of the tests. Simple procedures such as
comparing the current year account balance to the prior year account
balance is more attention directing (and provides less assurance) than
more complex analytical procedures; i.e., those which rely on regression
analysis. More sophisticated analytical procedures help the auditor
examine relationships between several information variables
simultaneously. The nature of these tests may provide greater
assurance than simple procedures. Except for certain accounts with
small dollar balances, analytical procedures are essential to help the
auditor identify trends in a client's business and to see the relationship
between the client's performance and industry averages. However, the
auditor is responsible for gathering sufficient appropriate evidence in
addition to the evidence obtained as a result of the analytical
procedures.

The purposes of audit documentation are as follows:

1. To provide a basis for planning the audit. The auditor may

use reference information from the previous year in order to
plan this year's audit, such as the evaluation of internal
control, the time budget, etc.
2. To provide a record of the evidence accumulated and the
results of the tests. This is the primary means of
documenting that an adequate audit was performed.
3. To provide data for deciding the proper type of audit report.
Data are used in determining the scope of the audit and the
fairness with which the financial statements are stated.
4. To provide a basis for review by supervisors and partners.
These individuals use the audit documentation to evaluate
whether sufficient appropriate evidence was accumulated to
justify the audit report.

Audit documentation are used for several purposes, both during the
audit and after the audit is completed. One of the uses is the review by
more experienced personnel. A second is for planning the subsequent
year audit. A third is to demonstrate that the auditor has accumulated
sufficient appropriate evidence if there is a need to defend the audit at a
later date. For these uses, it is important that the audit documentation
provide sufficient information so that the person reviewing an audit
schedule knows the name of the client, contents of the audit schedule,
period covered, who prepared the audit schedule, when it was

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prepared, and how it ties into the rest of the audit files with an index
code.

Sarbanes-Oxley Act of 2002 Issues:

The two criteria used by auditors of public companies when determining

whether memos, correspondence, and other documents must be
maintained in the audit files are as follows:

1. The materials are created, sent, or received in connection with

the audit or review.
2. The materials contain conclusions, opinions, analyses, or
financial data related to the audit or review.

The Act requires auditors of public companies to prepare and maintain

audit schedules and other information related to any audit report in
sufficient detail to support the auditors conclusions, for a period of not
less than 7 years. Audit schedules should include the following:

Name of the client Enables the auditor to identify the appropriate

file to include the audit schedule in if it is removed from the files.

Period covered Enables the auditor to identify the appropriate

year to which an audit schedule for a client belongs if it is
removed from the files.

Description of the contents A list of the contents enables the

reviewer to determine whether all important parts of the audit
schedule have been included. The contents description is also
used as a means of identifying audit files in the same manner that
a table of contents is used.

Initials of the preparer Indicates who prepared the audit schedule

in case there are questions by the reviewer or someone who
wants information from the files at a later date. It also clearly
identifies who is responsible for preparing the audit documentation
if the audit must be defended.

Date of preparation Helps the reviewer to determine the sequence

of the preparation of the audit schedules. It is also useful for the

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 subsequent year in planning the sequence of preparing audit
schedules.

Indexing Helps in organizing and filing audit schedules. Indexing

also facilitates in searching between related portions of the audit
documentation.

Audit Files

The permanent file contains data of an historical and continuing nature

pertinent to the current audit. Examples of items included in the file are:

1. Articles of incorporation
2. Bylaws, bond indentures, and contracts
3. Analysis of accounts that have continuing importance to the
auditor
4. Information related to the understanding of internal control:
a. flowcharts
b. internal control questionnaires
5. Results of previous years' analytical procedures, such as
various ratios and percentages compiled by the auditors

By separating this information from the current year's audit files, it

becomes easily accessible for the following year's auditors to obtain
permanent file data.

The audit files can also be subpoenaed by courts as legal evidence.

Unanswered questions and exceptions may indicate lack of due care by
the auditor. Tick marks are symbols adjacent to information in audit
schedules for the purpose of indicating the work performed by the
auditor. An explanation of the tick mark must be included at the bottom
of the audit schedule to indicate what was done and who did it.

Audit files are owned by the auditor. They can be used by the client if
the auditor wants to release them after a careful consideration of
whether there might be confidential information in them. The audit files
can be subpoenaed by a court and thereby become the property of the
court. They can be released to another CPA firm without the client's
permission if they are being reviewed as a part of a voluntary peer
review program under AICPA, state CPA society, or state Board of

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Accountancy authorization. The audit files can be sold or released to
other users if the auditor obtains permission from the client.

Audit testing with CAATS

When evidence can be examined only in machine-readable form,

auditors use computers to read and examine evidence. There are
commercial audit software programs designed specifically for use by
auditors, such as ACL Software and Interactive Data Extraction and
Analysis (IDEA). Spreadsheet software packages can also be used by
auditors to perform audit tests on data that is available only in machine-
readable form.

The purposes of audit documentation software are to convert

traditional paper-based documentation into electronic files and to
organize the audit documentation. The benefits of audit documentation
software, such as Automated Client Engagement (ACE), are as follows:

The auditor can more efficiently prepare a trial balance, lead

schedules, supporting audit documentation, financial
statements, and ratio analysis using the computer rather
than by hand.
The effects of adjusting journal entries are automatically
carried through to the trial balance and financial statements,
making last-minute adjustments easier to make.
Tick marks and review notes can be entered directly into
computerized files.
Data can be imported and exported to other applications. For
example, a clients general ledger can be downloaded into
ACE and tax information can be downloaded into a
commercial tax preparation package after the audit is
completed.

Audit objectives, evidence, procedures, and

documentation

This module revisits the overall objective of an audit and

expands on the interpretation of this objective. It considers the
difference between the audits objective and specific audit
objectives. You learn what constitutes sufficient appropriate
audit evidence and the general audit procedures used in a

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financial statement audit. The module concludes with an
overview of pre-engagement activities.

Elaborate on the overall objective of an audit of financial

statements.

The overall objective is to express an opinion as to

whether the financial statements, in all material
respects, present fairly the results of the companys
operations, its financial position, and its cash flows.

This can be restated as the objective "to detect any

material misstatements that exist, individually or in
aggregate."

Describe the auditor's responsibility to consider fraud and

error and the consequences of illegal acts in order to
achieve the objective of financial statement audits.

Misstatements can arise from error or fraud. (Fraud may

be either fraudulent financial reporting or
misappropriation of assets.)

It is the auditors responsibility to detect material

misstatements, however caused.

If an auditor detects a misstatement (that is, either a

misstatement resulting from a non-trivial error, or one
indicating a serious weakness in internal controls), the
auditor should immediately bring it to the attention of
the appropriate level of management and the audit
committee (or equivalent).

Any evidence of fraud discovered or suspected should be

communicated to the appropriate level of management
and the audit committee (or equivalent).

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 Any questions regarding management competence and
integrity should be communicated to the audit committee
(or equivalent).

The CICA Handbook defines illegal acts as "violations of

domestic or foreign statutory law or government
regulation attributable to the entity under audit, or to
management or employees acting on the entitys behalf."

Management is responsible for identifying and complying

with laws and regulations that affect the entity, as well
as preventing and detecting illegal acts. Management is
responsible for establishing policies and procedures to
accomplish this aim.

The auditor should attempt to identify laws and

regulations that, if violated, could be expected to result
in a material misstatement in the financial statements.

Discovery of possible illegal acts should be communicated

to the audit committee and other appropriate levels of
management.

Explain the various types of management assertions and

their relationship to specific audit objectives.

The five basic financial statement assertions are

o existence or occurrence
o completeness
o rights and obligations (ownership)
o valuation or allocation (measurement)
o presentation and disclosure

Specific audit objectives are to obtain and evaluate

sufficient appropriate evidence about each assertion.

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Explain how an auditor determines what and how much
evidence is required.

The appropriateness and sufficiency of evidence are a

matter of judgment and are influenced by the following
factors:
o materiality
o inherent risk and control risk considerations
o experience from prior audits
o the persuasiveness of the evidence
o error or fraud found during the audit

Describe and apply evidence-gathering audit procedures

commonly used to obtain audit evidence, and
describe the strengths and weaknesses of each
procedure.

Audit procedures (also called techniques or methods) include

computation, observation, confirmation, enquiry, inspection
(including tracing, scanning, and vouching), and analysis.

Computation by the auditor is strong evidence for the

valuation assertion but does not provide evidence of
existence or completeness.

Observation by the auditor is strong evidence for the

assertion of existence. Observation, however, does not
provide evidence on any other level. The existence of an
asset, for example, does not prove ownership.

Confirmation from third parties (if the auditor has

control over mailing and receipt) constitutes strong
evidence of existence and valuation because of the
independent form of the evidence. If, however, the
auditor does not have control over mailing and receipt,
then the clients opportunity to alter the responses
lessens the strength of the evidence obtained by the
procedure.

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 Direct enquiry by the auditor to third parties can be
strong evidence, but direct enquiry of internal parties is
considered weaker evidence. An assessment of the
source on the basis of integrity, independence from the
entity, and knowledge of the audit entity must always
accompany the use of direct enquiry.

Inspection consists of looking at records and documents

or at assets having physical substance. It encompasses
the following procedures:

o Vouching is used to examine documents that provide

evidence supporting the assertion of existence.

o Tracing provides evidence of completeness. Documents

held by third parties (bank loan documents on file at the
bank, for example) are most reliable. Third-party
documents held internally are less reliable, and
documents prepared by the entity and held by the entity
are the least reliable as they can be subject to
manipulation.

o Scanning alerts auditors to unusual items and events in

clients documentation.

When using analysis, the auditor must ensure that there

really is a meaningful relationship between amounts in
the data to allow the development of reasonable
expectations. It is also important to ensure that the level
of assurance that the expectations provide is consistent
with the objective of the analytical procedure. Analysis is
best used to highlight areas in the financial statements
that require further investigation and is less valuable as
hard evidence.

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Explain the issues related to the use of analysis to provide
audit evidence.

Analysis can be used at the planning stage of the audit to

help in determining the nature, extent, and timing of
audit work. Analysis can also be used to provide primary
evidence supporting specific assertions. At the
completion stage it can be used to help evaluate the
overall financial statement presentation.

If the analysis is used as primary evidence, it must be

more persuasive than if used only for planning and
review. The value of the analysis is limited by the
auditors ability to develop reasonable expectations and
by the reliability of the data used to perform the
analysis.

Describe the purpose of working papers in auditing.

Working papers document the work done during the audit

and the conclusions based on that work.

They provide evidence that the audit was carried out in

accordance with generally accepted auditing standards.

Describe the form and content of working papers required

in a professional engagement.

The form and content of documentation included in

working paper files are covered on pages 298 to 303 of
the text, CICA Handbook section 5145, and CGA Auditing
Guideline No. 5 (Reading 3-3).

The form and content of working papers are affected by

such factors as
o the terms of the engagement and the type of report
required
o the nature and complexity of the clients business

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 o the nature and condition of the clients control
environment and control system
o the need for review and supervision of work carried
out by assistants

Explain the key elements of good working papers.

Good working papers should normally include

o evidence of adequate audit planning
o a description of audit evidence obtained
o evidence of adequate supervision and review
o evidence that the financial statements agree with
the supporting records
o evidence of evaluation and disposition of
misstatements
o copies of correspondence with the client

Describe the main pre-engagement activities.

The main pre-engagement activities performed before

accepting an engagement include
1. assessing independence between the firm and
client
2. obtaining information such as past financial
statements and annual reports
3. communicating with the previous auditor
4. communicating with the clients bankers, lawyers,
and so on
5. considering any special requirements or risks
related to the engagement
6. assessing if the firm has the necessary resources
to complete the assignment

Identify the factors to consider when accepting a new

audit engagement.

The factors to consider when deciding to accept a new

engagement include
o business and/or financial relationships between the
firms personnel and the client

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 o client integrity
o business risk facing the client (that is, risk of
business failure)
o the likelihood of significant reservations in the
auditors report

Explain the purpose of an engagement letter and its main

features.

An engagement letter defines the terms of the audit

engagement to which the auditor and the client have
agreed. They usually refer to
o the nature and objectives of the audit
o managements responsibility for the financial
statements
o the risk that the audit will not identify all material
misstatements
o the fee structure
o a list of working papers for the client to prepare
o a confirmation of the terms of engagement by the
client

CICA Handbook Assurance, section 5110, Terms of

Engagement, provides guidance on establishing an
understanding of, and agreement on, the terms of the
engagement for the audit of financial statements.

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