Audit Evidence and
Documentation
Chapter 05
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
5-2
Audit 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 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
Standards 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
5-5
Combined Assertions
Used 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 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 Formula
AR = IR * CR * DR
AR = Audit risk
IR = Inherent risk
CR = Control risk
DR = Detection risk
5-8
Audit Risk
Figure 5. 2
5-9
Inherent 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
5-10
Assertions with high
inherent 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
5-11
Types 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
5-12
Appropriateness of Audit Evidence0
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
Audit Evidence
RELIABILITY TYPE EXAMPLE
High Physical Inventory Observation
Documentary
External Cutoff Bank Statement
External/Internal Purchase Invoice
Internal Sales Invoice
Low Client Representations Management Representation
Letter
5-14
Types 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
5-15
Common Audit Procedures
5-16
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
5-17
Substantive 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)
5-18
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.
5-19
Extent 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
5-20
General on Analytical
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
5-21
General on Analytical
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.
5-22
General on Analytical
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)
5-23
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
5-24
Identifying Potential Misstatements
5-25
Basic Approaches to Auditing
Accounting 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.
5-26
Auditing 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
5-27
Related 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
5-28
Functions 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
5-29
Sufficiency 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 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 Files
Current files
Current year working papers
Index and cross-referencing
Permanent files
Items of continuing audit
interest
5-32
5-33
Preparation of a Working Paper –
Figure 5.8