`Ch.7 auditing

Examples of physical examination

- Count inventory in warehouse -Examine fixed asset additions

Examples of confirmation

-Confirm accounts receivable balances of a sample of client customers -Confirm client's cash balance with bank

Audit documentation is used for several purposes, both during the audit and after the audit is completed.

1st of the uses is the review by more experienced personnel. 2nd is for planning the subsequent year audit. 3rd is to demonstrate that the auditor has accumulated sufficient appropriate evidence if there is a need to defend the audit at a later date.

Examples of reperformance

< Agree sales invoice price to approved price list < Match quantity on purchase invoice to receiving report

Permanent Files:

Contain data of a historical or continuing nature.

Short-Term Debt-Paying Ability:

cash ratio quick ratio current ratio

Profitability Ratios:

• Earnings per share • Gross profit percentage • Profit margin • Return on assets • Return on common equity

Appropriateness of Types of Evidence— Conclusions from the criteria:

• The effectiveness of a client's internal controls has significant influence on the reliability of most types of audit evidence, especially internal documentation and analytical procedures. • Physical examination and recalculation involve the auditor's direct knowledge and are likely to be highly reliable. • Inquiry alone is usually not sufficient to provide appropriate evidence to satisfy any audit objective.

Analytical procedures are required during two phases of the audit:

(1) during the planning phase to assist the auditor in understanding the client's business and industry and to assist in determining the nature, extent, and timing of work to be performed, and (2) during the completion phase, as a final review for material misstatements or financial problems. Analytical procedures are also often done during the testing phase of the audit as part of the auditor's further audit procedures, but they are not required in this phase.

EXAMPLE OFRELIABLE EVIDENCE

-Confirmation of a bank balance -Use of duplicate sales invoices for a large well-run company -Physical examination of inventory by the auditor -Letter from an attorney dealing with the client's affairs -Count of securities on hand by auditor

Ability to Meet Long-Term Debt Obligations:

-Debt to equity -Times interest earned

Examples of inspection

-Examine copies of monthly bank statements -Examine vendors' invoices supporting a sample of cash disbursement transactions throughout the year

FACTORDETERMINING RELIABILITY

-independence of provider -Effectiveness of client's internal controls -Auditor's direct knowledge -Qualifications of provider -Degree of objectivity

VI. Analytical Procedures Analytical procedures are an essential part of auditing. Purposes of Analytical Procedures During the Audit Engagement:

1. Analytical procedures are required in the planning phase as part of risk assessment to understand the client's business and industry. 2. Analytical procedures are often done during the testing phase of the audit as substantive tests in support of an account balance. 3. Analytical procedures are required during the completion phase of the audit, serving as a final review for material misstatements.

Reliability depends on the following characteristics:

1. Independence of provider 2. Effectiveness of client's internal controls 3. Auditor's direct knowledge 4. Qualifications of individuals providing the information 5. Degree of objectivity 6. Timeliness

Types of Analytical Procedures—Auditors compare client data with:

1. Industry data 2. Similar prior-period data 3. Client-determined expected results 4. Auditor-determined expected results

IV. Types of Audit Evidence Every audit procedure obtains one or more of the following types of evidence:

1. Physical examination 2. Confirmation 3. Inspection 4. Analytical procedures 5. Inquiries of the client 6. Recalculation 7. Reperformance 8. Observation

There are two primary reasons why the auditor can only be persuaded with a reasonable level of assurance, rather than be convinced that the financial statements are correct:

1. The cost of accumulating evidence. It would be extremely costly for the auditor to gather enough evidence to be completely convinced. 2. Evidence is normally not sufficiently reliable to enable the auditor to be completely convinced. For example, confirmations from customers may come back with erroneous information, which is the fault of the customer rather than the client.

II. Audit Evidence Decisions The auditor must make four major decisions regarding what evidence to gather and how much to accumulate:

1. Which audit procedures to use? 2. What sample size to select for a given procedure? 3. Which items to select from the population? 4. When to perform the procedures?

Four characteristics:

1.Receipt (Note negative confirmation of receivables as an exception.) 2. Written - we also note that they may be received electronically 3. From third party 4. Information requested by auditor

Examples of analytical procedures

< Evaluate reasonableness of receivables by calculating and comparing ratios < Compare expenses as a percentage of net sales with prior year's percentages

Examples of inquiries of the client

< Inquire of management whether there is obsolete inventory < Inquire of management regarding the collectibility of large accounts receivable balances

Examples of recalculation

< Inquire of management whether there is obsolete inventory < Inquire of management regarding the collectibility of large accounts receivable balances

Examples of observation

< Observe client employees in the process of counting inventory < Observe whether employees are restricted from access to the check signing machine

The purposes of audit documentation are as follows:

< To provide a basis for planning the audit. The auditor may use reference information from the previous year in order to plan this year's audit, such as the evaluation of internal control, the time budget, etc. < To provide a record of the evidence accumulated and the results of the tests. This is the primary means of documenting that an adequate audit was performed. < To provide data for deciding the proper type of audit report. Data are used in determining the scope of the audit and the fairness with which the financial statements are stated. < To provide a basis for review by supervisors and partners. These individuals use the audit documentation to evaluate whether sufficient appropriate evidence was accumulated to justify the audit report.

count

A determination of assets in hand at a given time.

Examine

A reasonably detailed study of a document or record to determine specific facts about it

Preparation of Audit Documentation

Audit documentation should be in sufficient detail to provide a clear understanding of the work performed, evidence obtained, and conclusions reached.

ÌII. Persuasiveness of Evidence

Audit standards require that the auditor accumulate sufficient appropriate evidence to support the opinion issued. The two determinants of the persuasiveness of evidence are appropriateness and sufficiency.

Inquiries of the Client

Define: Obtaining written or oral information from the client in response to auditor questions. Usually not considered conclusive unless it is corroborated.

Recalculation

Define: Rechecking a sample of calculations made by the client.

Inspection

Define: The auditor's examination of the client's documents and records to substantiate the information in the financial statements. Documents can be internal (prepared by the client's organization) or external (prepared or handled by someone outside the organization who is a party to the transaction).

Reperformance

Define: The auditor's test of client accounting procedures or controls. -Need for other evidence to test details even if no misstatements

Analytical Procedures

Define: The evaluation of financial information through analysis of plausible relationships among financial and nonfinancial data and are required during planning and completion phases of all audits.

Physical Examination

Define: The inspection or count of a tangible asset by the auditor. - Applies only to tangible assets -assets applicable to (cash, fixed assets, securities, etc.) -Provides an opportunity to have direct contact with business

Observation

Define: Watching a process or procedure being performed by others.

Appropriateness of evidence depends on:

Relevance of evidence Reliability of evidence

Relevance of evidence

Relevance of evidence means that the evidence must pertain to or be relevant to the audit objective that is being tested.

Reliability of evidence

Reliability of evidence refers to the degree to which evidence is believable or worthy of trust.

Tracing

Testing from source documents to recorded amounts (completeness objective)

Confidentiality of Audit Files:

The AICPA Code of Professional Conduct states that a member in public practice shall not disclose any confidential client information without the specific consent of the client.

Combined Effect

The persuasiveness of the evidence can be evaluated only after considering the combination of appropriateness and sufficiency. In making decisions about audit evidence, both persuasiveness and cost must be considered.

Confirmation

The receipt of a direct written response from a third party verifying the accuracy of information that was requested by the auditor.

vouching

Using documents to support recorded transactions (occurrence)

compute

a calculation done by the auditor independent of the client

recompute

a calculation done to determine whether a client's calculation is correct

compare

a comparison of information in two different locations. The instruction should state which information is being compared in as much detail as practical

The nature of evidence in a legal case and in an audit of financial statements differs because

a legal case relies heavily on testimony by witnesses and other parties involved. While inquiry is a form of evidence used by auditors, other more reliable types of evidence such as confirmation with third parties, physical examination, and inspection are also used extensively. A legal case also differs from an audit because of the nature of the conclusions made. In a legal case, a judge or jury decides the guilt or innocence of the defendant. In an audit, the auditor issues one of several audit opinions after evaluating the evidence.

scan

a less-detailed examination of a document or record to determine whether there is something unusual warranting further investigation

foot

addition of a column of numbers to determine whether the total is the same as the clients

read

an examination of written information to determine facts pertinent to the audit

trace

an instruction normally associated with inspection or reperformance.

I. Overview Audit evidence

as any information used by the auditor to determine whether the information being audited is stated in accordance with the established criteria.

In both a legal case and in an audit of financial statements, evidence is used

by an unbiased person to draw conclusions. In addition, the consequences of an incorrect decision in both situations can be equally undesirable. For example, if a guilty person is set free, society may be in danger if the person repeats his or her illegal act. Similarly, if investors rely on materially misstated financial statements, they could lose significant amounts of money. Finally, the guilt of a defendant in a legal case must be proven beyond a reasonable doubt. This is similar to the concept of sufficient appropriate evidence in an audit situation. As with a judge or jury, an auditor cannot be completely convinced that his or her opinion is correct, but rather must obtain a high level of assurance.

An audit program

includes all of the above information for a given audit. For example, an audit program for accounts receivable is a list of audit procedures that will be used to audit accounts receivable for a given client. The audit procedures, sample size, items to select, and timing should be included in the audit program.

An audit procedure

is the detailed instruction for the collection of a type of audit evidence that is to be obtained. Because audit procedures are the instructions to be followed in accumulating evidence, they must be worded carefully to make sure the instructions are clear.

VII. Audit Documentation

is the record of the audit procedures performed, relevant audit evidence, and conclusions the auditor reached.

Sufficiency

of evidence refers to the quantity of evidence obtained.

Ownership

of the Audit Files: All audit files are the property of the auditor.

For these uses, it is important that the audit documentation provide

sufficient information so that the person reviewing an audit schedule knows the name of the client, contents of the audit schedule, period covered, who prepared the audit schedule, when it was prepared, and how it ties into the rest of the audit files with an index code.

inquire

the act of inquiry should be associated with the type of evidence defined as inquiry

observe

the act of observation should be associated with the type of evidence defined as observation

vouch

the use of documents to verify recorded transactions or amounts

Liquidity Activity Ratios:

• Accounts receivable turnover • Days to collect receivables • Inventory turnover • Days to sell inventory

• Supporting Schedules—Major types:

• Analysis • Trial balance or list • Reconciliation of amounts • Substantive analytical procedures • Summary of procedures • Examination of supporting documentation • Informational • Outside documentation

Current Files:Includes all documentation for the current year audit including:

• Audit Program • Working Trial Balance—Each line in the trial balance is supported by a lead schedule. A typical lead schedule for Cash is included in Figure 7-4. • Adjusting Entries—Auditors propose adjusting entries for material misstatements. An adjusting entry to Cash is illustrated in Figure 7-4. • Supporting Schedules—Major types:

Requirements for Retention of Audit Documentation

• Auditing standards require records of private companies be retained for a minimum of five years. • Sarbanes-Oxley Act requires auditors of public companies to maintain audit files for a minimum of seven years.

These provide a convenient source of information that is used from year to year:

• Copies of company documents such as articles of incorporation, bylaws, bond indentures, and long-term contracts • Analyses of accounts from previous years that have continuing importance • Information related to understanding internal controls and assessing control risk • Results of analytical procedures from prior years' audits for comparison

Documentation should have these characteristics:

• Identified with the client's name, period covered, description of the contents, initials of the preparer, date of preparation, and an index code. • Files should be indexed and cross-referenced to aid in organization. • Documentation should clearly indicate the audit work performed through memos, initialing the procedures in the audit program, or tick marks on the schedules. • Include sufficient information to fulfill the audit objectives. • Conclusions reached about the segment of the audit should be clearly stated.

Cost of Types of Evidence:

• Most expensive: • Physical examination • Confirmation • Moderately costly: • Inspection • Analytical procedures • Reperformance • Least expensive: • Observation • Inquiries of the client • Recalculation

Common financial ratios Financial ratios fall into several categories:

• Short-Term Debt-Paying Ability: • Liquidity Activity Ratios: • Ability to Meet Long-Term Debt Obligations: • Profitability Ratios:

The sample size that is considered sufficient is affected by two factors:

• The auditor's expectation of misstatements • The effectiveness of the client's internal controls

Purposes of analytical procedures include:

• Understand the Client's Industry and Business—Used in planning to gain knowledge about the client. • Assess the Entity's Ability to Continue as a Going Concern—Many ratios can be an indicator of potential financial problems. • Indicate the Presence of Possible Misstatements in the Financial Statements—The presence of unusual fluctuations noted in comparing current and prior years could signal misstatements. • Provide Evidence Supporting an Account Balance—If reliable relationships exist, substantive analytical procedures can be used to support account balances.