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1
Audit Evidence:
A Framework
Rittenberg/Schwieger/JohnstoneAuditing: A Business Risk Approach
Sixth Edition
Chapter 5
Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
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Overview
Auditing is a process of objectively gathering, evaluating,
and documenting the evidence needed to provide assurance on the financial statements
In planning an audit, three questions need to be
answered: What audit procedures should be performed?
How much evidence is needed?
When should the audit procedures be performed?
The audit programs detail the auditor's plan to gather, evaluate, and document evidence
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Overview (continued)
The evidence gathering process is the core of the audit; evidence is needed toReduce audit riskSupport the opinion
In deciding which evidence to gather, the auditor considersRisk associated with an account balance or
other measures of performanceTypes of evidence availableReliability of alternative sources of evidence
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Third Standard of Fieldwork
Sufficient, competent evidential matter is to be obtained through audit procedures performed to
afford a reasonable basis for an opinion regarding the financial
statements under audit
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What is the assertion model?
The auditor gathers evidence to evaluate the management assertions embodied in the financial statements and individual accounts
Existence or occurrenceCompletenessRights and obligationsValuation or allocationPresentation and disclosure
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Gathering Sufficient, Competent Evidence
Because each audit is unique, there is no set amount or type of evidence that must be gathered
When considering the best approach to gather evidence, the auditor needs to consider factors affecting the reliability of the financial data:Management integrity
Client economic risk
Quality of client's information system
Client's control structure
Current market conditions and competitor actions
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The Steps in the OverallAudit Process
1. Understand the client and industry
2. Assess environment risk
3. Directly test transactions and/or account balances
4. Assess adequacy of evidence
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Sufficient, Competent Evidence
There are two dimensions to audit evidence: sufficient (quantity) and competent (quality/reliability)
The relationship between these dimensions is inverse: if evidence is of lesser quality, greater amounts must be collected (and vice versa)
When gathering evidence, auditors consider which procedures provide the most reliable evidence in the most efficient manner
Reliability depends on the circumstances under which evidence is gathered: Evidence obtained from independent outside sources is more reliable than
evidence obtained from the client
Evidence obtained from auditor's direct knowledge is more reliable than evidence obtained indirectly
Evidence obtained from client with strong internal controls is more reliable than evidence obtained from client with weak internal controls
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Internal Documentation
Reliability varies withQuality of client's internal controls
Management's motivation to misstate (fraud potential)
Formality of the documentation including acknowledgement by independent parties
Preparation of the document independently of the accounting system and management
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External Documentation
Generally considered highly reliable
External documents provided by a client should be viewed more critically than documents received directly from the external party
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Paper vs. Electronic Documentation
Major challenge for auditors to determine which electronic data is reliable
Computer systems can be designed to provide safeguards similar to paper-based systems
If auditor is going to rely on electronic data, he/she must develop an understanding of the
Client's computer system
Controls used to safeguard electronic data from manipulation or destruction
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The Nature of Audit Testing
When directly testing an account balance or
transactions, the auditor examines two
basic types of evidence
The underlying accounting data and records
Corroborating information that validates the
underlying accounting data
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The Nature of Audit Testing (continued)
Auditors have traditionally used direct tests of year-end account balances, as opposed to examining the transactions that make up the account balance
Generally,There are usually fewer items in the ending
balance than the number of underlying transactions during the year
More reliable evidence usually exists for an ending balance than for the underlying transaction
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The Nature of Audit Testing (continued)
However, for many long term accounts (assets, liabilities, owners' equity), the auditor may focus on the transactions that occurred during the audit period
For these accounts, There are usually fewer transactions during
the year than items in the ending balanceReliance forms of evidence are often
available
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Audit Procedures
The procedures an auditor will use vary according to the risks associated with the client and the methods used to record transactions.
Three major phases of the audit:Preliminary planning and risk analysisUnderstand and test systemTest account balances or other business
measurements
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Audit Procedures: Preliminary Planning and Risk Analysis
Review prior-year audit work
Review publicly available data about the organization
Perform analytical procedures
Inquire of management and employees
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Audit Procedures: Understand and Test the System
For all systems:Inquire of management and employeesReview system documentationObserve system in operationDocument system flow and control pointsSelect transactions and trace through processing
Additional work for computerized systems:Test important computer controlsUse computer software to trace transactions through
systemUse software to select transactions for further
verification
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Audit Procedures: Test Account Balances or Other Business
Measurements
Direct tests of account balances:Review authoritative records and documentsExamine client-retained documentationExamine outside documentationExamine electronic records
Testimonial evidence:Inquire of client personnelInquire of and analyze responses from
outside parties
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Auditor-generated evidence:Direct observationPerform re-computationsReprocess transactions from source documents to
accounting recordsVouch transactions from accounting records back to
source documentsPhysically examine assetsPerform analytical procedures
Each of these procedures has strengths and weaknesses; the auditor's task is to determine which procedures provide a sufficient level of evidence with the least amount of audit cost
Audit Procedures: Test Account Balances or Other Business
Measurements (continued)
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Directional Testing (Audit Efficiency)
Directional testing: auditor tests for over- or understatement, not both Increases audit efficiencyMisstatements are more likely to occur in one direction
(assets and revenues overstated, liabilities and expenses understated)
With directional testing, auditor uses procedures that focus on the most likely misstatements
Vouching and reprocessing are examples of directional tests
Can also provide evidence about complementary accounts
Some management assertions are directional by nature (existence addresses overstatement; completeness, understatement)
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Evidence-gathering Procedures
Auditors use a variety of procedures to gather evidence For certain accounts or management assertions, certain procedures
may be more efficient or effective than other procedures When writing audit programs, the auditor tries to use those procedures The primary types of audit procedures include: Observation of client personnel and procedures Physical examination of assets Inquiry Confirmations Examination of documents Re-computation of data Reprocessing transactions Vouching transactions Analytical procedures
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Evidence-gathering Procedures (continued)
Observation of client personnel and proceduresMost often used to gain an understanding of
client processing systemAlso used to observe counting of physical
inventoryLimitations:
Intrusive and time-consumingEmployees know they're being watched and act
differently; this makes it difficult to generalize the evidence obtained
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Evidence-gathering Procedures (continued)
Physical examination of assetsUseful in verifying existence of tangible
assets
May be useful in identifying potential obsolescence or wear and tear
Does not provide evidence on completeness, ownership, or proper valuation (except as in item above)
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Evidence-gathering Procedures (continued)
Inquiry Used extensively, especially early in the audit to gain an
understanding Efficient way to gather evidence Not considered persuasive, should be corroborated by other
sources of evidenceConfirmations Auditor sends letter to outside party asking them to verify client
information Considered strong evidence because they come from external
parties Limitations:
Respondents may not adequately check information being confirmed
Respondents may not respond in a timely fashionRespondents may not challenge figures in their favor
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Examination of documents Much of the audit process involves examining
documentsUseful for evaluating all of the assertionsAuditor should establish document
authenticity in order to rely on it
Recalculation Includes footing, cross-footing, tests of
extensions, re-computationOften used to test accuracy of estimated
accounts and allowances
Evidence-gathering Procedures (continued)
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Test of transactions involve reconciling source documents with recorded accounting information
Reprocessing Select sample of source documents and reprocess
them to make sure they have all been properly recorded
Includes reviewing journalizing and posting of the transaction
Helps establish completeness (all valid items have been recorded)
Evidence-gathering Procedures (continued)
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Vouching Reverse of reprocessingSelect sample of already recorded transactions and
trace back to the underlying source documentsHelps establish that recorded transactions are valid
(existence)
Analytics Compare recorded account balances (or ratios of
balances) to expectations developed by the auditorSources used to develop these expectations include
client's prior period information, industry data, expected results
Evidence-gathering Procedures (continued)
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Timing of Audit Procedures
In addition to what procedures to perform, the auditor must also decide when to perform themAs of the balance sheet dateAfter the balance sheet dateBefore the balance sheet date (interim testing)
Advantages of interim testing:Audit may be completed, and statements
distributed, soonerTypically means less overtime for audit staff
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Disadvantages of interim testing:Risk of material misstatement between
interim date and year-end
Interim testing is feasible:When client has strong internal controlsWhen there is low probability of significant
change in account balances between interim work and year-end
For accounts in which the auditor focuses on tests of transactions rather than the year-end balance (example: non-current assets)
Timing of Audit Procedures (continued)
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The Extent of Audit Procedures
In addition to deciding what procedures to perform and when to perform them, the auditor must also decide how much evidence is needed
The extent of testing is affected by:Auditor's assessment of the risk of account balance
misstatement
Amount of misstatement considered material
Persuasiveness of alternative forms of evidence
The amount of evidence may also be influenced by the auditor's individual risk preferences
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What are audit programs? (1)
Audit programs specify the audit objectives and procedures used to gather, document, and evaluate evidence
Audit programs guide the conduct of the audit and provide an effective means for:Organizing and distributing audit workMonitoring the audit processRecording audit work performedReviewing the audit procedures performed
and evidence gathered
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What is documenting audit evidence?
The audit work papers include all forms of documentation including:Evidence of planning, including audit programsThe client's trial balance and any auditor adjustmentsCopies of selected internal and external documents
including confirmation and representation letters and abstracts of company documents
Schedules prepared or obtained by the auditorAuditor memosResults of analytical procedures and tests of client
recordsAuditor analysis of account balance
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The work papers are the primary evidence in support of audit conclusions and should cover all relevant audit work, support the audit report, and leave no significant points unresolved
The work papers aid in the conduct and supervision of the work, facilitate performance of an effective review, demonstrate adherence to professional and Firm auditing standards and procedures, and assist in planning the following year's audit
What are audit programs? (2)
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Characteristics of Good Audit Documentation
Well-developed audit documentation contains:A heading that includes client name, explanatory title,
and balance sheet dateInitials of the auditor who prepared the documentation
and date completedInitials of the reviewer and date review completedDescription of the tests performed and the findingsAssessment of whether tests indicate material
misstatement in an accountTick marks and legend indicating work performed by
the auditorIndex to identify the location of papersCross-reference to related documentation, when
applicable
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Importance of Quality Review
Audits of corporations subject to SEC regulation must be subjected to a concurring partner review before the audit report is issued
The concurring partner should not be involved in the audit, but should have knowledge of the client's business and industry