Lecture 6

Various means of gathering audit evidence

Audit evidence is evidence obtained by auditors during a financial audit and recorded in the audit
working papers. Auditors need audit evidence to see if a company has the correct information
considering their financial transactions. Gathering audit evidence as part of an audit involves a
mix of techniques that are used interchangeably: visual observation, examination of records, and
employee interviews. Basically, audit evidence means evidence in support of the entries in books
of accounts. It is important because auditor’s opinion is based on audit evidence. Any auditor
who visits the client’s premises, will ask the management to show the book of Journal entries.
The Journal book contains all the transactions offer during the year. One by one all the Journal
entries are verified with the documents they are attached with.
Non statistical versus statistical audit sampling
An approach to sampling that involves random selection of the sample items and the use of
probability theory to evaluate the sample results, including the measurement of sampling risk is
known as statistical sampling. Any other approach is described as ‘non-statistical sampling’.
Statistical sampling allows each sampling unit to stand an equal chance of selection. The use of
non-statistical sampling in audit sampling essentially removes this probability theory and is
wholly dependent on the auditor's judgment. An organization processes on average thousands of
transactions every month. If we select 5 or 6 transactions per Month over a year, we will be
taking samples of over seventy. Whereas in statistical Sample of forty from the same population.
If we select a sample randomly, we cannot project the result of the population. From that
judgement sample of seventy we could only report about seventy transactions we looked at but
from the statistical sample of forty we can report a conclusion from the entire population.
Lecture 7
Planning and Designing the sample
Planning is the process of thinking about the activities required to achieve a desired goal. It
involves developing a strategy without this we cannot work properly. Audit sample planning
means creating a strategy for conducting an audit of financial statements.
When planning a particular sample for a substantive test of details, the auditor should consider
 The relationship of the sample to the relevant audit objective.
 Preliminary judgments about materiality levels
 The auditor's allowable risk of incorrect acceptance.
 Characteristics of the population, that is, the items comprising the account balance or
class of transactions of interest.
When planning a particular audit sample for a test of controls, the auditor should consider
 The relationship of the sample to the objective of the test of controls.
 The maximum rate of deviations from prescribed controls that would support his planned
assessed level of control risk.
 The auditor's allowable risk of assessing control risk too low.
 Characteristics of the population, that is, the items comprising the account balance or
class of transactions of interest.
Selection of the Sample
 Consider the objectives of the audit procedure. Objectives can be financial auditing cost
auditing or compliance auditing. According to that auditing procedure will be carried
out .
 Characteristics of the population.
 Assist in effective and efficient design of sample form a stratification must be
appropriate. Stratification is the process of dividing a population into subpopulations.
Determining the Sample Size
Non-statistical or judgmental sampling: auditor will calculate the sample size based on his
professional experience and knowledge
Statistical sampling: Mathematical formula are used, either in specially prepared tables or using
software designed for audio sampling.
Stratified sampling: It is allocated among the strata.
Sample selection method
 Random-number sampling: computer-generated numbers select sampling units to
match number to pre number documents which appropriate for both statistical and
nonstatistical sampling.
 Systematic sampling: Selects every “N” item from population of sequentially ordered
items. This will be used when there are no identification numbers or when identification
numbers lacking. Which means value of all samples is same.
 Block sampling: A sequential series of selections is made. For example, an auditor elects
to use block sampling to examine customer invoices and intends to pick 30 invoices from
80. It Should not be used for statistical or non-statistical sampling without care in
controlling sampling risk.
 Haphazard sampling: Haphazard sampling is a sampling method that does not follow
any systematic way of selecting participants. This method is inappropriate for statistical
sampling. But for non-statistical sampling it can be used.
 Stratified sampling: Stratified sampling is a type of sampling method in which the total
population is divided into groups or strata where the population will have some common
characteristics.
Other techniques
Sequential sampling: Sequential sampling is a non-probability sampling which performed in
stages of production. It will be auditor’s decision whether they want to continue sampling in
every stage or not.
Non-statistical sampling: Non-statistical sampling is the selection of a group that is based
on the Auditor's judgment. It is used when there is a lack of budget. Auditor judgment guided
by experience, prior knowledge and current information.
Sampling selection methods
Probabilistic Non-probabilistic
1. sampling risk requires. Where there is 1. Auditor often able to identify items
probability, there will be risk likely to contain errors
2. Simple random sample selection: every 2. Items containing selected
member of the population has an equal characteristics. Auditors are aware of
chance of being selected the characteristics for which items can
3. Systematic sample selection or be manipulated. Or for which this item
systematic sampling: an auditor can be a fraud.
calculates an interval and uses the 3. Large dollar item coverage. Auditors
interval to select sample will select items with significant value
and take them into account whether they
have any Error or not

Performing the audit procedures and evaluating the sampling results

Auditor applies the appropriate audit procedures to each item Kindle sample to determine
whether it is correct or contains a Misstatement.
 Nature: it contains technique and type of evidence. Technique includes computation,
observation, confirmation. Type of evidence can be internal or external.
 Timing: this tells us when the procedures are performed
  Extent: the amount of work done when procedures are performed many other techniques
are applied on a test basis
Sampling for tests of controls: attribute sampling
• Planning factors
1. Audit objective
2. Tolerable failure rate
3. Expected failure rate
4. Allowance for sampling error
5. Help will risk of accessing control risk too low
• Nonstatistical sampling
• attribute estimation sampling
• Attribute estimation sampling
1. Define the attributes of interest and failures
2. Define the population
 Time Covered by the tests
 sampling unit
 Ensuring the population is complete.
• the sample size
• Determine sample size
1. multiple attributes
2. Effect of population size
• Determine the method of selecting the sample
1. it can be random numbers
2. It can be sample selection
3. It can also be haphazard selection
• Evaluation of sample results can be of three types
1. Quantitative evaluation
2. Qualitative evaluation
3. Link to substantive testing
Attribute estimation sampling
1. Determine objectives, attributes, deviation conditions
2. Define population
3. Different sample size
4. Perform sampling plan
5. Evaluate sample results
Attribute estimation sampling: objectives – weather controls for class of transactions sufficiently
to lower control risk below maximum
• Trail of observable and documented evidence
• Does not rely primarily on segregation of duties
Attribute estimation sampling: sample size
Sample size components
Acceptable risk of assessing control risk too low
Inverse relationship with sample size
Tolerable rate of deviation
Maximum population rate of deviation from control
Expected population division rate
Estimated from prior your or pilot sample
Lecture 08
The 7 Steps of Monetary Unit Sampling
Monetary-unit sampling is a method of statistical sampling used to assess the amount of
monetary misstatement that may exist in an account balance. It is a statistical method of
sampling that is also called dollar unit sampling, cumulative monetary amount sampling, and
sampling with probability proportional to size.
1. Determine misstatements for each sample item.
2. Calculate misstatement per dollar unit in each sample item.
3. Layer misstatements per dollar unit from highest to lowest, including the percent
misstatement assumption for sample items not misstated.
4. Determine upper precision limit from attributes sampling table and calculate the percent
misstatement bound for each misstatement.
5. Calculate initial upper and lower misstatement bounds for each layer and total.
6. Calculate point estimate for overstatements and understatements.
7. Calculate adjusted upper and lower misstatement bounds.
Audit evidence and documentation
Audit evidence is kind of information or data that is used or collected by auditors as part their
audit works to conclude their opinion on whether or not financial statements are prepared in all
material respect and in accordance with following proper rules and regulation.
Accounting records are key sources of information and evidence used to prepare, verify and/or
audit the financial statements. They also include documentation to prove asset ownership for
creation of liabilities and proof of monetary and non-monetary transactions.
Other information other than accounting records or any relatable evidence are also very
important to documentation the audit evidence.
Audit evidence decision
1. Select Procedure
2. Select Sample Size
3. Select items from Populations
4. Perform the Procedure
Types of audit evidence
1. Physical examination: An example of this can be warehouse visit.
2. Confirmation: The records must be confirmed
3. Documentation: All the necessary documents must be checked whether they are valid or
not
4. Analytical procedures: substantive tests or natural
5. Inquiries of the client: Information can be checked by taking documents from the
management
6. Re-calculation: values need to be re calculated when required
7. Re-performance: Check whether everything is performed correctly and in proper order
8. Observation: It is important to observe all information and to have a skeptical mind as
well.
Sufficiency of audit evidence
Materiality: The concept refers to a situation where the financial information of a company is
material from the point of view of the preparation of the financial statements
Risk of material misstatement: The risk of material misstatement is the risk that the financial
statements of an organization have been misstated. It will be reduced if more audit evidence
is taken.
Size of the population: Population size is the number of items in a population. If the size of
the population is large, then more audit evidence must be taken.
Characteristics of population: Every item in population has equal chance of selection for
sampling and each selected item for sample must be equal. Sometimes characteristics of the
population must be considered as well. Account receivable, cash, Asset, research and
development- in areas like this, information can be manipulated.
Competency of Evidence
 Relevance of audit evidence: Must be checked whether the material misstatement is
relevant to the audit evidence
 Reliability of audit evidence: How did evidence must be collected from only the sources
which are reliable.
 Professional judgment: A competency will develop if the auditor has years of experience
and knowledge
Documentation
Audit documentation is the written record of the basis for the auditor's conclusions that
provides the support for the auditor's representations, whether those representations are
contained in the auditor's report. Audit documentation also may be referred to as work papers
or working papers. There are two types of documentation. They are Internal & External
documentation.
Documenting audit evidence
The audit work papers include all forms of documentation including:
 Evidence of planning, including audit programs
 The client's trial balance and any auditor adjustments
 Copies of selected internal and external documents including confirmation and
representation letters and abstracts of company documents
 Schedules prepared or obtained by the auditor
  Auditor memos
 Results of analytical procedures and tests of client records
 Auditor analysis of account balance
Characteristic of good audit documentation
well-developed audit documentation contains
 A heading that includes clients name, exponentially title, Balance sheet date .
 Initials of the auditor who prepared the documentation and data completed.
 Initials of the reviewer and date review completed. Reviewer can be a third party.
 Description of the tests performed and the findings
 Assessment of whether tests indicate material misstatement in an account
 Tick marks and legend indicating work performed by the auditor.
 Index to identify the location of papers. An index will be prepared which will tell us
which paper is located where.
 Cross reference Related documentation, when applicable.
Nature of the revenue cycle
1. cash receipts (collections on accounts and cash sales)
2. credit sales (sales made on accounts)
3. sales adjustments (discounts, sales returns and allowances, and uncollectible accounts.
Revenue and collection cycle: key control procedures
 Separation of duties
o Separate functions for recording, authorization, custody
 Authorization of transactions
o Write offs
o Credit checks prior to approval of sale
o Pricing
 access to assets
o Shipping Department
o Lock box account
 Adequate documents and records
o Pre numbered sales orders, shipping documents, sales invoices
 Independent checks on performance
o A/R subsidiary Ledger to general
o monthly statement to customer

Lecture 09
 Account Balances and Transactions:
1. Reprocessing transactions: While transaction a card needs to be reprocessed when a
transaction was initially declined or when a transaction encountered an error scenario.
2. Vouching of transactions: It is the act of reviewing documentary evidence to see if it
properly supports entries made in the accounting records
3. Analytical procedures: To check the balances substantive testing and financial ratios
are carried out and verified
General balance related audit objectives
 Existence - amounts included exist.
 Completeness- existing amounts are included.
 Accuracy - amounts included are stated at the correct amounts
 Classification- amounts are properly classified.
 Cutoff- transactions are recorded in the proper Period
 Detail tie in – account balances agree with master file amounts, and with the Ledger
 Realizable value- estimated realizable value
 Rights and obligations- assets must be owned
Transaction testing
Transactional tests are compliance tests that are conducted contemporaneously with the activity
in question and are used to detect deviations of actual transactions from firm policies or
regulatory standards.
1. Statistical sampling: Samples collected or selected from a statistical population by a
defined procedure.
2. Stratified sampling: Total population is divided into smaller groups or strata to complete
the sampling process.
3. Judgmental something: Samples are chosen only based on the researcher’s knowledge
and judgment.
Transaction related audit objectives for sales
 Occurrence: recorded sales are for shipments made
 Completeness: existing sales transactions are recorded
 Existing sales transactions are recorded accuracy: recorded sales are for an amount
shipped
 posting in summarization colon sales transactions or correctly included in the accounts
receivable Masterfile full stop
 Classification: sales transactions are correctly classified
 Timing colon sales are recorded on the correct dates

Lecture 10
 Test of controls and not spending of transactions for cash receipts
Determine whether cash received was recorded: It is a procedure to test whether all recorded
cash receipts have been deposited in the bank account or not.
Prepare proof of cash receipts*: The Bank reconciliation compares the amount of cash shown on
the bank statement with the amount of cash reported in the general ledger. These two balances
will frequently differ. Differences are caused by items reflected on company records but not yet
recorded by the bank.
Test to discover lapping of accounts receivable*: Lapping can be detected by conducted a
periodic review of the cash receipts records, to trace payments to outstanding receivables.
*Only performed when fraud is suspected

The Expenditure Cycle

The expenditure cycle is the set of activities related to the acquisition of and payment for goods
and services. These activities include the determination of what needs to be purchased,
purchasing activities, the receipt of goods, and payments to suppliers. Much of the input to the
expenditure cycle comes from the sales cycle, where purchasing requirements are driven by the
volume and type of customer orders. The expenditure cycle is comprised of several distinct
components, including the requisition of goods and services, supplier selection, the ordering of
goods and services, their receipt, and subsequent payment for them.

Substantive Tests of Accounts Payable Balances

Determining Detection Risk for Tests of Details: When an auditor fails to identify a material
misstatement in a company's financial statements.
Existence and Occurrence: It deals with whether assets or liabilities exist at a given date and
whether recorded transactions have occurred.
Completeness: Weather the accounts transactions is complete or not.
Rights and Obligations: Rights and obligations are an underlying assertion used in the
construction of financial statements, stating that the organization has title to its stated assets and
has an obligation to pay its stated liabilities.
Valuation and Allocation: It means that amounts at which assets, liabilities and equity interests
are valued, recorded and disclosed are all appropriate.
Presentation and Disclosure: The final financial statement assertion is presentation and
disclosure.
 Sales and Collection Cycle
Accounts Documents Controls
1. Sales 1. Customer order 1. Separation of duties
2. Cash 2. Sales order 2. Authorization
3. Accounts receivable 3. sales invoice 3. Documentation
4. Sales discount 4. Bill of lading 4. pre number to documents
5. Sales returns and 5. Additional documentation 5. Monthly statements
allowances 6. Internal verification
6. Allowance for
uncollectible accounts
7. Bad debts expense
 Lecture 11
Audit of Inventory and Cost of Goods Sold
Inventory is a complex accounting and auditing area because of -
 Diversity of items: The number and types of inventory is not certain. Most of the
company deals with various inventory
 High Volume: Inventory produces in high volume to consume. It requires higher number
cost to manage them.
 Various accounting valuation methods: There are usually 3 valuation methods. FIFO,
LIFO and weighted average
 Obsolete inventory: Obsolete inventory is a term that refers to inventory that is at the
end of its product life cycle.

Inventory
Audit of inventories are complex because -
 Many frauds involve inflating inventory
 Inventory easily transportable
 Multiple locations
 Difficulty identifying obsolete inventory
 Defective inventory
 Valuation
 Returned goods
 Diversity of products
 Complex valuation methods

Audit of inventory
Part of Audit Cycle in which tested
1. Acquire and record raw materials, labor, 1. Acquisition and payment plus payroll
and overhead and personnel
2. Internally transfer assets and costs 2. Inventory and warehousing
3. Inventory and warehousing 3. Sales and collection
4. Physically observe inventory 4. Inventory and warehousing
5. Price and compile inventory 5. Inventory and warehousing

Assertions, objective, and procedures

Management assertions
Management assertions are claims made by members of management regarding certain aspects
of a business. The concept is primarily used regarding the audit of a company's financial
statements, where the auditors rely upon a variety of assertions regarding the business.
 Exist: All account balances exist for assets, liabilities, and equity.
 Include all transactions: All business events to which the company was subjected to
recorded.
 Represent rights of entry: The entity has the rights to the assets it owns and is obligated
under its reported liabilities.
 Are valued properly: All asset, liability, and equity balances have been recorded at their
proper valuations.
 Are present and disclosed properly: The information included in the financial
statements has been appropriately presented and is clearly understandable.

Objectives and Procedures (Existence or Operations)

 Objectives: determine whether all recorded sales, receivables, cash balances or not
 Procedures
 Existence
 Physical observation
 Confirmation
 Transactions occurred
 Cutoff testing for proper period

Objectives and procedures (Completeness)

 Objective: determine whether all receivables false. And sales represented in financial
statements are not
 Procedures
 Examine Documents
 Applying Analytics Procedures
 Cutoff bank statement, bank reconciliation, etc.

Objectives and procedures (Rights and obligations)

 Objective: Determine whether entity has property rights to cash, accounts receivable or
not
 Procedures: It includes examining documentation, confirmations, and inquiries
Objectives and procedures: (Valuation and Allocation)
 Objective: Determine whether entity has recorded items incorrect amounts, accounts,
and time periods or not
 Procedures: It includes confirming balances, verifying mathematical accuracy, and
examining details of recording

Objectives and procedures (Presentation and disclosure)

 Objective: Determine whether recorded transactions from a balance properly classified,
disclosed or not
 Procedure: Compare presentation to GAAP, annual updates of AICPA guidelines