Audit Evidence and Documentation

Chapter 05

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

5-2

Audit RiskAudit Risk

The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated

This is the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP.

Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.

5-3

Financial Statement AssertionsFinancial Statement Assertions

Relevant assertions are those that, without regard for controls, have a reasonable possibility of containing a material misstatement; types Assertions about account balances

(Accounts) Assertions about classes of transactions and

events (Transactions) Assertions about presentation and disclosure

(Disclosures)

5-4

Financial Statement Assertions: Auditing Financial Statement Assertions: Auditing

Standards Board and International StandardsStandards Board and International Standards Accounts Transactions Disclosures

Existence Occurrence Occurrence

Rights and obligations

Rights and obligations

Completeness Completeness Completeness

Valuation and allocation

Accuracy Accuracy and valuation

Cutoff

Classification Classification and understandability

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Combined Assertions Combined Assertions Used in this TextUsed in this Text

Existence or Occurrence--Assets, liabilities, and equity interests exist and recorded transactions have occurred

Rights and Obligations--The company holds rights to the assets, and liability are the obligations of the company

Completeness--All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded

Cutoff—Transactions and events have been recorded in the correct accounting period

Valuation, Allocation and Accuracy—All transactions, assets, liabilities and equity interests are included in the financial statements at proper amounts

Presentation and Disclosure--Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressed

5-6

Audit RiskAudit Risk

Risk of Material Risk That the Audit Risk = Misstatement * Auditors Fail to the Misstatement

= Inherent Control Detection Risk * Risk * Risk

Inherent Risk--Risk of a material misstatement occurring in an assertion assuming no related internal controls.

Control Risk--Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control.

Detection Risk--Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.

5-7

Audit Risk FormulaAudit Risk Formula

AR = IR * CR * DR

AR = Audit riskIR = Inherent riskCR = Control riskDR = Detection risk

5-8

Audit Risk

Figure 5. 2

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Inherent RiskInherent Risk

Factors that affect inherent risk: Nature of the client and its environment Nature of the particular financial statement element

Business characteristics indicative of high inherent risk: Inconsistent profitability of client Operating results highly sensitive to economic factors Going concern problems Large known and likely misstatements detected in prior audits Substantial turnover, questionable reputation, or inadequate

accounting skills of management

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Assertions with high Assertions with high inherent riskinherent risk

Involve: Difficult to audit transactions or balances Complex calculations Difficult accounting issues Significant judgment by management Valuations that vary significantly based on

economic factors

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Types of TransactionsTypes of Transactions

Routine Recurring financial statement activities recorded in the

accounting records in the normal course of business Lower inherent risk

Nonroutine Involve activities that occur only periodically such as the taking

of physical inventories High inherent risk

Estimation transactions Activities that create accounting estimates Higher inherent risk

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Appropriateness of Audit Appropriateness of Audit Evidence0Evidence0

Auditor must obtain sufficient appropriate audit evidence.

To be appropriate audit evidence must be: Relevant Reliable

Principles—Audit evidence is ordinarily more reliable when it is

Obtained from knowledgeable independent sources outside the company rather than nonindependent sources

Generated internally through a system of effective controls rather than ineffective controls.

Obtained directly by the auditor rather than indirectly or by inference

Documentary in form rather than oral Provided by original documents rather than copies

5-13

Reliability of Certain Types of Reliability of Certain Types of Audit EvidenceAudit Evidence

RELIABILITY TYPE EXAMPLEHigh Physical Inventory Observation

DocumentaryExternal Cutoff Bank StatementExternal/Internal Purchase InvoiceInternal Sales Invoice

Low Client Representations Management Representation Letter

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Types of Audit EvidenceTypes of Audit Evidence

1. Accounting information system

2. Documentary evidence

3. Third-party representations

4. Physical evidence

5. Computations

6. Data interrelationships

7. Client representations

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Common Audit ProceduresCommon Audit Procedures

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Overall Types of Audit Procedures Overall Types of Audit Procedures

Risk assessment procedures To obtain an understanding of the client and its

environment, including its internal control, to assess the risks of material misstatement

Further Audit Procedures Tests of controls

When appropriate, to test the operating effectiveness of controls in preventing material misstatements

Substantive procedures To detect material misstatements at relevant assertion level.

Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosures

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Substantive ProceduresSubstantive Procedures Analytical procedures Tests of details

• Tests of account balances• Tests of classes of transactions• Tests of disclosures

One may change the scope of audit procedures by changing the (NTE, or re-ordered as NET):

• Nature (type and form)• Timing (when performed)• Extent (quantity of evidence obtained)

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Nature and Timing of Procedures Nature and Timing of Procedures

Holding the extent of procedures constant, one may increase the scope of procedures (make them more effective) by either changing the

Nature-- obtain more reliable evidence• often externally generated evidence.

Timing--wait until year-end to obtain evidence from entire set of transactions as contrasted to performing interim testing, say two months prior to year-end and simply updating those procedures.

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Extent of ProceduresExtent of Procedures

Holding other factors such as the nature and timing of procedures constant: The greater the risk of material misstatement,

the greater the needed extent of substantive procedures

The main way to increase the extent of audit procedures is to examine more items

Sample sizes should reduce detection risk so as to restrict audit risk to a low level

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General on Analytical General on Analytical Procedures (1 of 3)Procedures (1 of 3)

Timing of analytical procedures Risk assessment (sometimes referred to as planning

analytical procedures) Substantive procedures Final review

Steps involved Develop expectation of account (or ratio) balance Determine amount of difference that can be accepted without

investigation Compare the company’s account (ratio) with the expectation Investigate and evaluate significant differences

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General on Analytical General on Analytical Procedures (2 of 3)Procedures (2 of 3)

Developing an expectation Prior period information Anticipated results Relationships among elements of financial information within a

period Industry information Relationships between financial information and relevant

nonfinancial data.

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General on Analytical General on Analytical Procedures (3 of 3) Procedures (3 of 3)

Types of Expectations Trend analysis—analyze changes in accounts of a

company over time Ratio analysis – compare relationships between two

or more financial statement accounts or comparisons of account balances to nonfinancial data

• Liquidity (e.g., current ratio)• Leverage (e.g., debt to equity)• Profitability (e.g., gross profit percentage)• Activity (e.g., inventory turnover)

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Ratio Analysis Ratio Analysis Approaches to ratio analysis

Horizontal analysis• Review ratios over time

Cross sectional analysis• Analyze ratios of similar firms at a point in time

Vertical analysis• Analyze relationships within a period

• “Common size” statements prepared Other methods

• Regression analysis, reasonableness test

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Identifying Potential Misstatements

5-25

Basic Approaches to Auditing Basic Approaches to Auditing Accounting EstimatesAccounting Estimates

Review and test management’s process for developing the estimate.

Independently develop an estimate to compare to management’s estimate.

Review subsequent events or transactions bearing on the estimate.

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Auditing Fair ValuesAuditing Fair Values Inputs to use in applying valuation techniques (FAS

157) Level 1 – inputs of observable quoted prices in

active markets for identical assets or liabilities• Ex. A closing stock price in WSJ

Level 2 – inputs of observable quoted prices, generally for similar assets or liabilities in active markets

• Ex. Company discounts future cash flows on its not publicly traded debt securities at rate used by market for publicly traded debt securities

Level 3 – inputs that are unobservable for the assets or liability

• Ex. A private company uses judgment to determine a proper rate to discount the future cash flows of its not publicly traded securities

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Related Party TransactionsRelated Party Transactions

Disclosure requirements must be met Primary challenge is identifying

undisclosed related party transactions Determine related parties

• Inquiries of management• Review SEC filings, stockholder’s listings and

conflict-of-interest statements Be alert for transactions with related parties

and any transactions with unusual terms

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Functions of Audit DocumentationFunctions of Audit Documentation

Primary functions:•Support the auditors’ compliance with auditing standards•Support the auditors’ opinion

Secondary functions:•Assist continuing and new audit team members in planning and performing the audit

•Serves as a record of matters of continuing audit interest•Assists in supervision and review of the audit•Demonstrates the accountability of team members•Assists internal reviewers, external peer reviewers, PCAOB inspectors, and successor auditors in performing their roles

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Sufficiency of Audit DocumentationSufficiency of Audit Documentation

Audit documentation should be sufficient to: Enable an experienced auditor to understand the

work performed and the significant conclusions reached

Identify who performed and reviewed the work Show that the accounting agree or reconcile to the

financial statements Audit documentation should include all

significant audit findings and the actions taken to address them

5-30

Types of Working PapersTypes of Working Papers

Audit administrative working papers Working trial balance Lead schedules Adjusting journal entries and reclassification

entries Supporting schedules Analysis of a ledger account Reconciliations Computational working papers Corroborating documents

5-31

Types of Working FilesTypes of Working Files

Current files Current year working papers Index and cross-referencing

Permanent files Items of continuing audit

interest

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5-33

Preparation of a Working Paper – Preparation of a Working Paper – Figure 5.8Figure 5.8