AUDITING - AUDIT EVIDENCE

AC 732 TOPIC SEVEN

AUDIT EVIDENCE

7.1 Concept of Audit Evidence

Audit evidence refers to 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. Audit evidence is cumulative in nature, and includes audit evidence obtained from audit procedures performed during the course of the audit and may include audit evidence obtained from other sources such as previous audits and a firm’s quality control procedures for client acceptance and continuance.

The accumulation of Audit evidence is guided by ISA 500: Audit Evidence, though some other ISAs are also there to deal with some more specific items of audit evidence

ISA 500 requires that the auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion.

7.2 Sources of Audit Evidence

The auditor can obtain some audit evidence by testing the accounting records from which the financial statements are prepared, for example, through analysis and review, re-performing procedures followed in the financial reporting process, and reconciling related types and applications of the same information. Through the performance of such audit procedures, the auditor may determine that the accounting records are internally consistent and agree to the financial statements. However, because accounting records alone do not provide sufficient audit evidence on which to base an audit opinion on the financial statements, the auditor should obtain other audit evidence.

Other information that the auditor may use as audit evidence includes minutes of meetings; confirmations from third parties; 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 information developed by, or available to, the auditor that permits the auditor to reach conclusions through valid reasoning.

7.3 Sufficient Appropriate Audit Evidence

Sufficiency is the measure of the quantity of audit evidence, while appropriateness is the measure of the quality of audit evidence; that is, its relevance and its reliability in providing support for, or detecting misstatements in, the classes of transactions, account balances, and disclosures and related assertions. 

The quantity of audit evidence needed is affected by the risk of misstatement (the greater the risk, the more audit evidence is likely to be required) and also by the quality of such audit evidence (the higher the quality, the less may be required). Accordingly, the sufficiency and appropriateness of audit evidence are interrelated although merely obtaining more audit evidence may not compensate for its poor quality.

            

7.4 Relevance of Audit Evidence

A given set of audit procedures may provide audit evidence that is relevant to certain assertions, but not others. For example, inspection of records and documents related to the collection of receivables after the period end may provide audit evidence regarding both existence and valuation, although not necessarily the appropriateness of period-end cutoffs. On the other hand, the auditor may often obtain audit evidence from different sources or of a different nature that is relevant to the same assertion. For example, the auditor may analyze the aging of accounts receivable and the subsequent collection of receivables to obtain audit evidence relating to the valuation of the allowance for doubtful accounts. Furthermore, obtaining audit evidence relating to a particular assertion, for example, the physical existence of inventory, is not a substitute for obtaining audit evidence regarding another assertion, for example, the valuation of inventory.

7.5 Reliability of Audit Evidence

The reliability of audit evidence is influenced by its source and by its nature and is dependent on the individual circumstances under which it is obtained.

Generalizations about the reliability of various kinds of audit evidence can be made; however, such generalizations are subject to important exceptions. Even when audit evidence is obtained from sources external to the entity, circumstances may exist that could affect the reliability of the information obtained. For example, audit evidence obtained from an independent external source may not be reliable if the source is not knowledgeable. While recognizing that exceptions may exist, the following generalizations about the reliability of audit evidence may be useful: i] Audit evidence is more reliable when it is obtained from independent sources outside the entity.

ii]               Audit evidence that is generated internally is more reliable when the related controls imposed by the entity are effective.

iii]             Audit evidence obtained directly by the auditor (for example, observation of the application of a control) is more reliable than audit evidence obtained indirectly or by inference (for example, inquiry about the application of a control).

iv]             Audit evidence is more reliable when it exists in documentary form, whether paper, electronic, or other medium (for example, a contemporaneously written record of a meeting is more reliable than a subsequent oral representation of the matters discussed).

v]               Audit evidence provided by original documents is more reliable than audit evidence provided by photocopies or facsimiles.

In addition to the above generalizations, the ISA 500 requires that when information produced by the entity is used by the auditor to perform audit procedures, the auditor should obtain audit evidence about the accuracy and completeness of the information. This can be achieved by seeking corroborative evidence, meaning that the auditor can obtain more assurance from consistent audit evidence obtained from different sources or of a different nature than from items of audit evidence considered individually. For example, corroborating information obtained from a source independent of the entity may increase the assurance the auditor obtains from a management representation.  When audit evidence obtained from one source is inconsistent with that obtained from another, the auditor should determine what additional audit procedures are necessary to resolve the inconsistency.

7.6 Efficiency/Cost of Obtaining Audit Evidence.

The auditor should consider the relationship between the cost of obtaining audit evidence and the usefulness of the information obtained. However, the matter of difficulty or expense involved is not in itself a valid basis for omitting an audit procedure for which there is no alternative.

In forming the audit opinion the auditor is not expected to examine all the information available because conclusions ordinarily can be reached by using sampling approaches and other means of selecting items for testing. 

7.7 Audit Evidence Decisions 

A key decision the auditor must make is the appropriate types and amounts of evidence to draw conclusions regarding financial statements or internal control. You might suggest that all evidence available should be used--but unfortunately, the cost of sampling every piece of evidence in a population would be prohibitive. In practice, the profession of auditing often requires taking a sample, and then drawing a conclusion based on that sample.

There are four types of decisions that an auditor must make:

1.      Which audit procedures should be used?

2.      What sample size should be selected for the procedure?

3.      Which items should be selected from the population? 

4.      When should the procedures be performed?

Each of these types of decisions is described briefly in your text, along with an example. Note how the example audit procedure is modified to include the sample size, specification of which items to choose, and the timing of the sample.

A collection of audit procedures (each including sample sizes, items to choose and timing) is called an audit program

7.8 Audit Procedures for Obtaining Audit Evidence

The auditor usually obtains audit evidence to draw reasonable conclusions on which to base the audit opinion by performing audit procedures to: i] Obtain an understanding of the entity and its environment, including its internal control, to assess the risks of material misstatement at the financial statement and assertion levels.

[Risk Assessment Procedures] ii] When necessary or when the auditor has determined to do so, test the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level. [Tests of Controls]

iii]      Detect material misstatements at the assertion level [Substantive Procedures]

The risk assessment procedures are performed to provide a satisfactory basis for the assessment of risks at the financial statement and assertion levels. Risk assessment procedures by themselves do not provide sufficient appropriate audit evidence on which to base the audit opinion, however, and are supplemented by further audit procedures in the form of tests of controls, when necessary, and substantive procedures.

Tests of controls are necessary in two circumstances. When the auditor’s risk assessment includes an expectation of the operating effectiveness of controls, the auditor is required to test those controls to support the risk assessment. In addition, when substantive procedures alone do not provide sufficient appropriate audit evidence, the auditor is required to perform tests of controls to obtain audit evidence about their operating effectiveness.

Substantive procedures are performed to be responsive to the related assessment of the risks of material misstatement, which includes the results of tests of controls, if any. The auditor’s risk assessment is judgmental, however, and may not be sufficiently precise to identify all risks of material misstatement. Further, there are inherent limitations to internal control, including the risk of management override, the possibility of human error and the effect of systems changes. Therefore, substantive procedures for material classes of transactions, account balances, and disclosures are always required to obtain sufficient appropriate audit evidence.

The procedures to obtain audit evidence, in accordance to ISA 500 are:

i]               Inspection of Records or Documents

ii]             Inspection of Tangible Assets

iii]           Observation iv]           Inquiry

v]                   Confirmation

vi]                 Recalculation

vii]               Re-performance

viii]             Analytical Procedures

7.8.1 Inspection of Records or Documents

Inspection consists of examining records or documents, whether internal or external, in paper form, electronic form, or other media. Inspection of records and documents provides audit evidence of varying degrees of reliability, depending on their nature and source and, in the case of internal records and documents, on the effectiveness of the controls over their production. An example of inspection used as a test of controls is inspection of records or documents for evidence of authorization.

Some documents represent direct audit evidence of the existence of an asset, for example, a document constituting a financial instrument such as a stock or bond. Inspection of such documents may not necessarily provide audit evidence about ownership or value. In addition, inspecting an executed contract may provide audit evidence relevant to the entity’s application of accounting policies, such as revenue recognition.

Inspection of Tangible Assets

Inspection of tangible assets consists of physical examination of the assets. Inspection of tangible assets may provide reliable audit evidence with respect to their existence, but not necessarily about the entity’s rights and obligations or the valuation of the assets. Inspection of individual inventory items ordinarily accompanies the observation of inventory counting.

7.8.2 Observation

Observation consists of looking at a process or procedure being performed by others. 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 and by the fact that the act of being observed may affect how the process or procedure is performed. 

7.8.3 Inquiry

Inquiry consists of seeking information of knowledgeable persons, both financial and nonfinancial, throughout the entity or outside the entity. This audit procedure is used extensively throughout the audit and often is complementary to performing other audit procedures. Inquiries may range from formal written inquiries to informal oral inquiries. It is important to note here that evaluating responses to inquiries is an integral part of the inquiry process.

Responses to inquiries may provide the auditor with information not previously possessed or with corroborative audit evidence. Alternatively, responses might provide information that differs significantly from other information that the auditor has obtained, for example, information regarding the possibility of management override of controls. In some cases, responses to inquiries provide a basis for the auditor to modify or perform additional audit procedures.

The auditor should perform audit procedures in addition to the use of inquiry to obtain sufficient appropriate audit evidence. Inquiry alone ordinarily does not provide sufficient audit evidence to detect a material misstatement at the assertion level. Moreover, inquiry alone is not sufficient to test the operating effectiveness of controls.

Although corroboration of evidence obtained through inquiry is often of particular importance, in the case of inquiries about management intent, the information available to support management’s intent may be limited. In these cases, understanding management’s past history of carrying out its stated intentions with respect to assets or liabilities, management’s stated reasons for choosing a particular course of action, and management’s ability to pursue a specific course of action may provide relevant information about management’s intent.

In respect of some matters, the auditor should obtain written representations from management to confirm responses to oral inquiries. For example, the auditor ordinarily obtains written representations from management on material matters when other sufficient appropriate audit evidence cannot reasonably be expected to exist or when the other audit evidence obtained is of a lower quality. 

7.8.4 Confirmation

Confirmation, which is a specific type of inquiry, is the process of obtaining a representation of information or of an existing condition directly from a third party. For example, the auditor may seek direct confirmation of receivables by communication with debtors. Confirmations are frequently used in relation to account balances and their components, but need not be restricted to these items. For example, the auditor may request confirmation of the terms of agreements or transactions an entity has with third parties; the confirmation request is designed to ask if any modifications have been made to the agreement and, if so, what the relevant details are. 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. 

7.8.5 Recalculation

Recalculation consists of checking the mathematical accuracy of documents or records. Recalculation can be performed through the use of information technology, for example, by obtaining an electronic file from the entity and using CAATs to check the accuracy of the summarization of the file.

7.8.6 Reperformance

Reperformance 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, reperforming the aging of accounts receivable.

7.8.7 Analytical Procedures

Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and non-financial data. Analytical procedures also encompass the investigation of identified fluctuations and relationships that are inconsistent with other relevant information or deviate significantly from predicted amounts.

7.9 Types of Evidence

•      Physical evidence

•      Third-party representations

•      Documentary evidence

•      Computations

•      Data Interrelationships

•      Client representations

•      Accounting records

7.9.1 Physical Evidence

Evidence that can actually be seen by auditors. This type of evidence is generally effective for supporting testing existence and condition of the asset. Example –inspection of a fixed asset.

Third Party Representations

The receipt of a written or oral response from an independent third party.  Auditor has client request that the third party respond directly to the auditor

•      Confirmations o Positive Confirmations

Asks for response even if balance is correct o Negative Confirmations

Asks for a response only if balance is incorrect

•      Lawyers’ Letters

•      Reports of Specialists

7.9.2 Documentary Evidence

Four basic types (helps determine reliability):

•      Created by outside parties and transmitted directly to auditor

•      Created by outside parties and held by client

•      Created and held by client

•      Electronic documents

7.9.3 Computations Computations are:

•      Performed independently by auditor 

•      Used to verify mathematical accuracy of client’s analyses and records

7.9.4 Analytical

Data interrelationships (i.e., analytical procedures) rely on plausible relationships among financial and non-financial data.

 Effective for testing “reasonableness” of certain account balances. Can be used as primary or corroborating evidence, depending on the nature of account

7.9.5 Oral and Written Client Representations

Responses to questions and inquiries to clients during an audit constitute audit evidence.

•      Oral representations are generally not sufficient as primary evidence, but may provide corroboration for other evidence.

•      Written representations (representation letter) are required, but should not be used as a substitute for other audit procedures.

7.9.6 Accounting Records

Clients’ accounting records (e.g. ledgers and journals) may provide worthwhile evidence in themselves.

 Depends on the effectiveness of internal controls

7.10 Characteristics of Competent Audit Evidence

The seven characteristics of competent evidence include:

1.      Relevance--to the audit objective that the auditor is testing;

2.      Independence of the provider--information received from outside the entity is presumed to be more reliable than from inside the entity. 

3.      Effectiveness of the client's internal controls--evidence from a client whose internal controls are effective is more trustworthy.

4.      Auditor's direct knowledge--data or calculations prepared by someone inside the organization will not be as reliable as data computed or discovered by the auditor directly.

5.      Qualifications of the individuals providing the information--reliability of the information is enhanced if the person providing it is qualified to do so.

6.      Degree of objectivity--objective evidence is more reliable than evidence that is subjective.

7.      Timeliness--data that are timely for the purpose intended are considered more reliable.

Sufficiency of evidence refers to the quantity of evidence, In part, sufficiency relates to the sample size that the auditor selects, but the individual items selected for the sample may have a bearing as well.

TUTORIAL QUESTIONS

Question One

 “Audit evidence” is all the information used by the auditor in arriving at the conclusions on which the audit opinion is based. Therefore, the gathering of audit evidence is a fundamental step in the audit process. 

Requirement  

In respect of International Standards on Auditing 500 Audit Evidence, you are required to: 

(i). Set out five procedures that International Standards on Auditing 500 identify for gathering audit evidence and illustrate the application of these procedures by way of examples. 

(ii). Using assumed data, prepare a work paper for an audit test that documents the use of one of the audit evidence gathering procedures outlined in 1 above in the sales cycle of an audit client who has a group of retail shops. The work papers should adhere to best practice in relation to the documentation of audit evidence. 

(iii).  Indicate three factors that would be relevant in judging the reliability of audit evidence. 

QUESTION TWO

 Which of the following are procedures and which are evidence?  

1  Inspecting non-current/fixed assets for signs of obsolescence

2  An item of inventory/stock that is present at the inventory/stock count

3  A bank statement

4  Counting petty cash

5  A working paper showing a re-calculation of depreciation

6  A sales invoice

7  Attending a wages pay out.

QUESTION THREE

You are the manager in charge of the audit of Kiboko Co., a listed company with a African-wide chain of fashion stores for babies and expectant mothers. The audit for the year ended 30 September 2006 is nearing completion. The draft financial statements show a profit before tax of Tshs50.6m (2005: Tshs. 95.3m).

The audit senior has produced a schedule of ‘Points for the attention of the audit manager’ as follows:

(a)    Due to the falling birth rate, the performance of the stores in Sudan has been worse than expected. An impairment review was performed on 15 October 2006, treating the Sudan’s stores as a single cash-generating unit, which indicated that the recoverable amount of the assets (based on value in use) was Tshs 23m lower than the carrying value. 

(b)   The company self-manufactures many of its clothing lines, and has a factory in Cape Town, RSA. Research has shown that the company could achieve substantial cost savings by outsourcing to south east Asia, and the factory in Cape Town is to be closed. A provision of Tshs3.2m to cover redundancy costs has been included in the 2006 draft financial statements.

(c)    The company is planning to open 20 new stores in south east Asia in the next year. To assist in financing the expansion, the company sold a number of its properties on 28 September 2006 for Tshs200m and leased them back under operating leases. 

Required:  

For each of the above points:

(i)                 Comment on the matters that you should consider; and

(ii)               State the audit evidence that you should expect to find, in undertaking your review of the audit working papers and financial statements of Kiboko Co.

QUESTION FOUR

Audit working papers are an integral part of an examination in accordance with generally accepted auditing standards.

 

(a)   Describe three major functions of the audit working papers.

(b)   Distinguish between the permanent working paper file and the current working paper file

QUESTION FIVE

The auditor can obtain information necessary to gain an understanding of the entity from internal and external sources. In respect of contextual financial information, identify two internal sources and two external sources where the auditor can obtain information for the purposes of his audit. 

QUESTION SIX

Audit staff from a renowned firm of Public Practice in Auditing need to obtain evidence on financial statements of a client company before audit report would be issued to shareholders and other stakeholders. 

Required: 

(a)  Briefly describe sufficiency, relevance and reliability in relation to the three attributes of audit evidence. 

(b)  What is analytical review procedures in audit assignment?