BUS425 CH 6 Audit Evidence

AICPA's AU-C 500 definition of "sufficient audit evidence"

"It]he measure of the quantity of audit evidence. The quantity of the audit evidence needed is affected by the auditor's assessment of the risks of material misstatement and also by the quality of such audit evidence."

AU-C 500 defines a management's specialist as:

"an individual or organization possessing expertise in a field other than accounting or auditing, whose work in that field is used by the entity to assist the entity in preparing the financial statements." *Failure to hire such an expert when such expertise is necessary increases the risks of material misstatement and may be a significant deficiency or material weakness in internal control

The auditor wants to review a sufficient number of transactions to determine that:

(a) other controls are not being overridden by management (b) there is support for the adjusting entries, for example, underlying data analyses (c) the entries are properly approved by the appropriate level of management.

The effectiveness of a substantive analytical procedure depends on several factors, including:

(a) the nature of the assertion being tested (b) the plausibility and predictability of the relationships in the data (c) the availability and reliability of the data used to develop the expectation (d) the precision of the expectation that the auditor develops (e) the rigor of the analytical procedure employed.

External documentation is generally highly reliable, but the reliability varies depending on whether the documentation:

(a) was prepared by a knowledgeable and independent outside party (b) is received directly by the auditor *Most external documentation, however, is received directly by the client

Audit documentation should contain:

- A heading that includes the name of the audit client, an explanatory title, and the balance sheet date - The initials or electronic signature of the auditor performing the audit rest and the date the test was completed - The initials or electronic signature of the manager or partner who reviewed the documentation and the date the review was completed - A unique workpaper page number - A description of the tests performed (including the items looked at) and the findings - Tick marks and a tick mark legend indicating the nature of the work performed by the auditor - A conclusion as to whether the work performed indicates the possibility of material misstatement in an account - A cross-reference to related documentation, when applicable - A section that identifies all significant issues that arose during the audit and how they were resolved

Reasonableness test

- A more rigorous approach to substantive analytical procedures - auditor develops an expected value of an account by using data partly or wholly independent of the client's accounting information system

PCAOB requires that the auditor document significant findings, as well as the actions taken to address them (including additional evidence obtained, where applicable). Factors auditor will include:

- Description of significant accounting issues that were identified during the course of audit and how they were resolved, including any correspondence with national office experts - A clear articulation of the auditor's judgment and the reasoning process that led to the judgment on the fairness of the financial statements

In deciding to perform substantive analytical procedures, the auditor considers the following questions:

- Does the organization have effective internal controls over the account? (The more effective a client's internal controls, the greater reliance an auditor can place on substantive analytical procedures; if not effective internal controls auditor has to perform more tests of details than substantive analytical procedures) - Is the risk of material misstatement low enough that inferences from indirect evidence, such as substantive analytical procedures, are appropriate to make conclusions about an account? - Are the underlying data used in evaluating an account both relevant and reliable? - Are the relationships among the data logical and justified by current economic conditions?

The reliability of internal documentation is influenced by:

- Effectiveness of internal controls over the documents - Management motivation to misstate individual accounts (fraud potential) - Formality of the documentation, such as acknowledgment of its validity by parties outside the organization or independent of the accounting function - Independence of those preparing the documentation from those recording transactions

Limitations of observation

- Observation of processing is rarely unobtrusive. Individuals who know they are being observed may act differently than when not observed - Observation of processing on one day does not necessarily indicate how the transactions were processed on a different day or over a relevant period

Regression analysis

- One of the most rigorous approaches to analytical procedures - the expected, or predicted, value is determined using a statistical technique where one or more factors are used to predict an account balance Example: the auditor may develop a repression model that predicts revenue for a client that has hundreds of retail stores. The factors used in the model might include store square footage, economic factors such as employment data, and geographical location

For any particular account, assertion, or disclosure, the auditor may choose from the following options for substantive procedures:

- Performing only substantive analytical procedures (in practice, this approach would rarely be used) - Performing only substantive tests of details - Performing a combination of substantive analytical procedures and tests of details

Step 6 (more detail with e types of audit procedures)

- Planning analytical procedures: Significant unexpected differences suggest that substantive procedures for the account/assertion will be increased - Substantive analytical procedures: The auditor should hypothesize as to the possible reasons for the difference, inquire of management as to possible reasons for the difference, and obtain evidence to quantify and corroborate these possible reasons. The auditor may need to increase the tests of details for the relevant account/assertion - Review analytical procedures: The auditor should perform additional procedures as necessary to form an overall conclusion about whether the financial statements are consistent with the auditor's understanding of the entity

What forms the foundation for the Audit.

Risk assessment procedures, so they should be documented

Significant findings or issues

essential matters that are important to the analysis of the fair presentation of the financial statements

External confirmations consist of:

sending an inquiry to an outside party to corroborate information. The outside parties are asked to respond directly to the auditor as to whether they agree or disagree with the information, or to provide additional information that will assist the auditor in evaluating the correctness of an account balance. *External confirmations include requests to legal counsel for an assessment of current litigation and the client's potential liability, letters to customers asking whether they owe the amount on the client's accounts receivable records, and letters to banks confirming bank balances and loans

Roll-forward period

the period between the interim date and the balance sheet date

Step 3 (more detail with 3 types of audit procedures)

- Planning analytical procedures; Objective: Identify accounts with heightened risk of misstatement during audit planning to provide a basis for designing and implementing responses to the assessed risks Precision of expectation: Less precise - Substantive analytical procedures: Objective: Obtain evidence regarding the accuracy of account balance/assertion Precision of expectation: More precise -Review analytical procedures: Objective: Assist the auditor in forming an overall conclusion about whether the financial statements are consistent with the auditor's understanding of the entity Precision of expectation: Less precise

AS 1215 provides the following examples of significant finding or issues:

- Significant matters involving the selection, application, and consistency of accounting principles, including related disclosures. (Significant matters include, but are not limited to, accounting for complex or unusual transactions, accounting estimates, and uncertainties, as well as related management assumptions) - Evidence indicating a need for modifying planned auditing procedures. - Results of auditing procedures signifying the existence of material misstatements, omissions in the financial statements, significant deficiencies, or material weaknesses in internal control over financial reporting - Evidence requiring audit adjustments. (An audit adjustment is a correction of a misstatement of the financial statements that was or should have been proposed by the auditor, whether or not recorded by management, which could, either individually or when aggregated with other misstatements, have a material effect on the company's financial statements.)

Timing of Procedures

- at the balance sheet date - earlier than the balance sheet date (interim) - after the balance sheet date *auditor determines which based on risk associated with the account, the effectiveness of internal controls, the nature of the account, and the availability of audit staff)

Relevance of evidence

- determines whether the evidence provides insight on the validity of the assertion the auditor is testing - relates to the connection between the audit procedure being performed and the assertion being audited

More reliable evidence according to IAASB in ISA 500

- directly obtained evidence (e.g. observation of control) - evidence derived from a well-controlled information system - evidence from independent outside sources - evidence that exists in documentary form - evidence from original documents

Less reliable evidence according to IAASB in ISA 500

- indirectly obtained evidence (e.g. an inquiry about the working of a control) - evidence derived from a poorly controlled system or easily overridden information system - evidence from within the clients organization - evidence obtained through inquiry - evidence obtained from photocopies or facsimiles, or digitalized data (would depend on quality of controls over their preparation and maintenance)

Common documents the auditor looks at include:

- invoices (to establish cost and ownership of inventory or various expenses) - payroll time cards - bank statements

Substantive analytical procedures

- not simple techniques - part of a difficult decision-making process designed to provide evidence about the correctness of an account balance - should be used when the procedures are reliable AND more cost effective than other substantive procedures

The audit program provides an effective means of:

- organizing and distributing on it

AS 1105

- provides guidance in determining the consistency and reliability of the evidence -highlights that the auditor needs to consider all sources of evidence, as well as the consistency of the evidence, in determining whether the evidence clearly leads to a conclusion about the fairness of the financial statement presentation

AS 1215 notes

- that the documentation provides the basis for conclusions reached on the audit, and document how the auditor reached significant conclusions - ""Audit documentation should be prepared in sufficient detail to provide a clear understanding of its purpose, source, and the conclusions reached. Also, the documentation should be appropriately organized" to provide a clear link to the significant findings or issues.

Audit Documentation

- the record that forms the basis for the auditor's repre- sentations and conclusions - facilitates the planning, performance, and supervision of the audit and forms the basis of the review of the quality of the work performed - Documentation may be in paper or in electronic form - must stand on its own - should include information about planning and risk assessment procedures (including the response to risk assessment procedures), audit work performed (including tests of controls and substantive procedures), conclusions reached, and significant issues identified and their resolution - serves as evidence that the auditors took their responsibilities seriously in evaluating potential problems

Factors that affect the reliability and relevance of information produced by a management's specialist

-Competence, capabilities, and objectivity of the specialist -Work performed by the specialist -Appropriateness of the specialist's work as audit evidence for the relevant assertion

Important documents the auditor usually obtains:

-Evidence of internal controls over financial reporting, as well as supporting records such as checks, invoices, and contracts - The general and subsidiary ledgers -Journal entries - Worksheets supporting cost allocations, computations, reconciliations, and disclosures

Types of Recalculations Performed by the Auditor

-Footing: Adding a column of figures to verify the correctness of the client's totals - Cross-footing: Checking the agreement of the cross-addition of a number of columns of figures that sum to a grand total. For example, the sum of net sales and sales discounts should equal total sales. -Tests of extensions: Recomputing items involving multiplication (eg-multiplying unit cost by quantity on hand to arrive at extended cost) - Recalculating: estimated amounts Recomputing an amount that the client has already estimated, such as recomputing the allowance for doubtful accounts based on the cient's formula related to the aging of accounts receivable ending balances

Factors affecting evidence reliability!

-source - nature - circumstances in which auditor obtained evidence

Relevance is affected by:

-the purpose of the procedure being performed -the direction of testing -the specific procedure or set of procedures being performed *evidence can be indirectly or directly related to an assertion

Steps in performing analytical procedures

1. Determine the suitability of a particular analytical procedure for given account (s)/assertion(s), considering the risks of material misstatement and tests of details planned 2. Evaluate the reliability of data that the auditor is using to develop an expectation of account balances or ratios. (In evaluating data reliability, the auditor should consider the source of the data, its comparability, the nature of information available about the data, and the controls over the preparation of the data.) 3. Develop an expectation of recorded account balances or ratios, and evaluate whether that expectation is precise enough to accomplish the relevant objective. The expectation can be about an account balance, a ratio, or other expected relationship. 4. Define when the difference between the auditor's expectation and what the client has recorded would be considered significant. 5. Compare the client's recorded amounts with the auditor's expectation to determine any significant unexpected differences. 6. Investigate significant unexpected differences. 7. Ensure that the following have been appropriately documented: auditor's expectation from Step 3, including the factors that the auditor considered in developing the expectation, the results in Step 4, and the audit procedures conducted in Steps 5 and 6.

Inspection of tangible assets generally provides reliable evidence with respect to _____ but not ______

Existence of the asset; NOT about the clients rights or completeness of the assets

3 categories of audit procedures and when auditors use them:

1. Risk assessment procedures: use during audit planning to identify the risks of material misstatement. 2. Test of controls: relevant when the auditor wants to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements 3. Substantive procedures: relevant when the auditor wants to obtain direct evidence about material misstatements in the financial statements

When determining sample sizes for a substantive test of details, such as confirmations, what should the auditor consider?

1. Risk of material misstatement 2. the assurance obtained from other substantive procedures performed by the auditor 3. the type of control being tested 4. Frequency with which the control has been tested 5. If data analytics tools are used (can test much more than if they do it manually) *the better the control environment, the smaller the sample size will be

Appropriateness of audit evidence

A measure of the quality of audit evidence, and includes both the relevance and reliability of the evidence.

Cutoff period

A period of time usually covering several days before and after the client's balance sheet date. The greatest risk of recording transactions is the wrong period occurs during the cutoff period

A vendor invoice is typically _______ documentation

External (but auditor will typically obtain it from the client)

True or false: inquiry alone provides sufficient audit evidence of account balances and is sufficient to test the operating effectiveness of controls

FALSE

current file

File that includes schedules, documents, and analyses that are relevant to the current-year audit. (Includes findings from substantive tests and tests of controls)

Communicating (usually through a confirmation) with a client's customers about whether the customer owes payment for goods to the client provides.... (Direct or indirect evidence?)

Direct evidence about the existence of an accounts receivable balance

Audit program

Documents the procedures the auditor plans to perform in gathering audit evidence and records the successful completion of each audit step

Performing procedures prior to the balance sheet date (interim) allows:

Earlier completion of audit and might require less overtime of the audit staff but also increases the risk of material misstatement occurring between the interim date and year end *when performing procedures at interim date, auditor needs to perform additional audit procedures at or after year end to make sure no misstatements have occurred during roll-forward period could be substantive procedures possibly combined with tests of controls)

Analytical Procedures

Evaluations of financial information through analysis of plausible relationships among both financial and nonfinancial data.

Corroboration

Involves obtaining sufficient evidence that the explanation is accurate (The auditor must not just accept clients explanation without corroborating evidence)

Observation involves

Looking at a clients process or procedure

What are Assets and revenues are typically tested for and why?

Overstatements because the usual presumption is that managers would prefer to show more assets and revenues.

True or false: The process for performing analytical procedures is the same regardless of whether the analytical procedures are performed during planning, as a substantive test, or during the final review

TRUE

If the client has little risk of material misstatement, internal controls are effective, and they have relatively non complex transactions,

The auditor could likely perform less rigorous substantive procedures or only a minimal amount of substantive procedures, and the audit would therefore be less costly to conduct

What is determined to be sufficient and appropriate is affected by...

The clients risk of material misstatement (its inherent and control risks) or risk of material weakness in internal control *will vary across accounts and assertions

Some assertions are directional by nature.

The existence/occurrence assertion addresses overstatement; the completeness assertion addresses understatement. Therefore, the assertion the auditor is testing determines the direction of testing and what type of evidence is relevant

Performing procedures after year-end may provide:

The most convincing evidence

The types of substantive procedures selected depend on

The risk of material misstatement

The purpose of an audit procedure is...

To determine whether it is a risk assessment procedure, a test of controls, or a substantive procedure

3 types of analytical procedures that tend to be less rigorous:

Trend analysis, ratio analysis and scanning

True or false: Controls over adjusting entries require additional consideration as adjusting entries represent a high risk of material misstatement.

True

In areas where significant risks of material misstatement exist, it is _______ that audit evidence obtained from substantive analytical procedures alone will be sufficient

Unlikely; auditor will likely also need to perform substantive tests of details

Vouching

Vouching involves taking a sample of recorded transactions and obtaining the original source documents supporting the recorded transaction (from subsidiary/general ledger to source doc) Example: for a sample of items recorded in the sales journal, the auditor will obtain the related shipping documents and customer orders. Vouching provides evidence on the assertion that recorded transactions are valid (existence/occurrence)

Reliability of evidence

Whether the evidence is convincing

When should audit documentation be completed and assembled?

Within 45 to 60 days (depending on the type of client) following the audit report release date * after that date, the auditor must not delete or discard audit documentation before the end of the required retention period (generally seven years from the report release date)

The quantity of audit evidence needed is affected by the:

auditor's assessment of the risks of material misstatement (the higher the assessed risks, the more audit evidence is likely to be required) and by the quality of such audit evidence (the higher the evidence quality, the less evidence may be required)

permanent files

auditors' files that contain data of a historical or continuing nature pertinent to the current audit such as copies of articles of incorporation, bylaws, bond indentures, and contracts

When determining the audit procedures to perform, recognize that audit firms need to:

be profitable AND manage risk

Indirect evidence

can be relevant, but not as directly relevant, to an assertion For example, tests of controls provide direct evidence about the operating effectiveness of controls and indirect evidence about accounts and assertions

After identifying risks of material misstatement and making a plan for responding to those risks, auditors...

execute that plan by performing audit procedures to obtain audit evidence

Prior to the report release date, the auditor must

have completed all necessary auditing procedures and obtained sufficient eridence to support the representations in the auditor's report

substantive tests of details might include

inspection of documentation, external confirmations, and recalculations.

Disaggregation

involves breaking data down into their component parts, such as different periods, geographical locations, customer type, or product lines

Quantification

involves determining whether an explanation for the difference can account for the amount of the difference

Tracing

involves taking a sample of original source documents and ensuring that the transactions related to the source documents have been recorded in the appropriate journal and general ledger (from source doc to subsidiary/general ledger) For example, the auditor might select a sample of receiving reports and trace them to the acquisitions journal and the general ledger

Reperformance

involves the auditor's independent execution of controls that the client originally performed as part of the client's internal control. *For example, rather than only inspecting documents related to a bank reconciliation to determine whether the reconciliation was performed, the auditor may reperform bank reconciliations for selected months and compare them to the reconciliations prepared by the client

Sufficiency of evidence

is the measure of the quantity of audit evidence (e.g., a sample size of documents that the auditor will review or the number of observa- tions of a control activity)

Internal documentation includes the following types of documents:

legal, business, accounting, and planning and control

Irrespective of the assessed risks of material misstatement, the auditor should:

perform substantive procedures for all relevant assertions related to each material account balance and disclosure

Directional testing involves:

testing balances primarily for either overstatement or understatement (but not both).

Cutoff tests

tests to determine whether transactions recorded a few days before and after the balance sheet date are included in the correct period (how much they test also depends on risk)

If the available audit evidence from a client is of lower quality (they have higher risk of material misstatement and internal controls aren't effective),

the auditor will have to find other high-quality evidence to corroborate evidence obtained from within the client's systems. (perform more, and more rigorous, substantive procedures) and this is more costly

When performing tests of controls, the extent of evidence necessary to persuade the auditor that the control is effective depends on.....

the risk associated with the control, that is, the risk that the control might not be effective and, if not effective, the risk that a material misstatement could occur. *As the risk associated with the control being tested increases, the evidence that the auditor should obtain also increases.

A primary benefit of performing substantive analytical procedures is that

they can reduce the need to perform additional, possibly more costly, substantive tests of details.

Why does the auditor obtain evidence?

to reduce the risk of issuing an unqualified opinion on financial statements containing a material misstatement or on internal control that has a material weakness

Scanning

type of analytical procedure involving the auditor's review of accounting data to identify significant or unusual items to test (can be done manually or using data analytic tools) *Unusual individual items might include entries in transaction listings, subsidiary ledgers, general ledger control accounts, adjusting entries, reconciliations, or other detailed reports.

What are liabilities and expenses typically tested for and why?

understatement because the usual presumption is that managers would prefer to show fewer liabilities and expenses