Chapter 5: Evidence and Doccumentation

Format of Audit Documentation

Below

Assertions about Account Balances, and Related Disclosures, at the Period End

Below (maybe come back to these?)

Profitability Ratios

Profitability ratios indicate the entity's success or failure for a given period. A number of ratios measure the profitability of an entity, and each ratio should be interpreted by comparison to industry data.

Data Reliability

The ability to develop precise expectations is influenced by the reliability of the available data. The reliability of data for developing expectations depends on the independence of the source of the evidence, the effectiveness of internal controls, and the auditor's direct personal knowledge. In addition, data for analytical procedures are more reliable when the data are subjected to audit in the current or prior periods and when the expectation is developed from multiple sources of data

Confirmation

A confirmation represents audit evidence obtained by the auditor as a direct written response to the auditor from a third party (the confirming party) in paper form or by electronic or other medium. 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. Auditors usually use the term inquiry to refer to unwritten questions asked of the entity's personnel or of a third party, and the term confirmation to refer to written requests for a written response from a third party The reliability of evidence obtained through external confirmations may be affected by factors such as: - The form of the confirmation. - Prior experience with the entity. - The nature of the information being confirmed. - The intended respondent. Confirmations are used extensively on audits; they generally provide reliable evidence for the existence assertion and, in testing certain financial statement components (such as accounts payable), can provide evidence about the completeness assertion. Evidence about other assertions can also be obtained through the use of confirmations. For example, an auditor can send a confirmation to a consignee to verify that an entity's inventory has been consigned. The returned confirmation provides evidence that the entity owns the inventory (rights and obligations assertion).

Reliability of Records or Documents

A previous section noted the independence of the source of evidence as a factor that affects the reliability of audit evidence. In particular, evidence obtained from a source outside the entity is generally considered more reliable than evidence obtained solely from within the entity. Typically, a distinction is made between internal and external documents. Internal documents are generated and maintained within the entity; that is, these documents have not been seen by any party outside the entity's organization. Examples include duplicate copies of sales invoices and shipping documents. External documents are of two forms: documents originating within the entity but circulated to independent sources outside the entity and documents generated outside the entity but included in the entity's accounting records. Examples of the first include remittance advices returned with cash receipts from customers and payroll checks, while examples of the second include bank statements and vendors' invoices.

Heading

All audit documentation should have a proper heading. The heading should include the name of the entity, the title of the working paper, and the entity's year-end date. Exhibit 5-2 shows a working paper with a proper heading.

Activity Ratios

Activity ratios indicate how effectively the entity's assets are managed. Only ratios related to accounts receivable and inventory are discussed here because for most wholesale, retail, or manufacturing companies these two accounts represent the assets that have high activity. Activity ratios may also be effective in helping the auditor determine if these accounts contain material misstatements

|The Audit Testing Hierarchy

After the auditor has gathered sufficient evidence about the entity and its environment using risk assessment procedures, the audit testing hierarchy starts with tests of controls and substantive analytical procedures. Starting with tests of controls and substantive analytical procedures is generally both more effective and more efficient than starting with tests of details.

Analytical Procedures

Analytical procedures are an important type of evidence. They consist of evaluations of financial information through analysis of plausible relationships among both financial and nonfinancial data. For example, the current-year accounts receivable balance can be compared to the prior years' balances after adjusting for any increase or decrease in sales and other economic factors. Similarly, the auditor might compare the current-year gross margin percentage to the gross margin percentage for the previous five years. The auditor makes such comparisons either to identify accounts that may contain material misstatements and require more investigation or as a reasonableness test of the account balance. Analytical procedures are an effective and efficient form of evidence and are increasing in breadth and scope due to the increasing use of audit data analytics, which allow auditors to visualize and analyze large sets of data for notable relationships using a variety of techniques. Analytical procedures can be used by an auditor to accomplish three purposes: 1.) Risk assessment procedures to assist the auditor to better understand the business and to plan the nature, timing, and extent of audit procedures (sometimes referred to as planning or preliminary analytical procedures). 2.) Substantive analytical procedures are used as a substantive procedure to obtain evidential matter about particular assertions related to account balances or classes of transactions. 3.) Final analytical procedures are used as an overall review of the financial information in the final review stage of the audit. The reliability of analytical procedures is a function of (1) the availability and reliability of the data used in the calculations, (2) the plausibility and predictability of the relationship being tested, and (3) the precision of the expectation and the rigor of the investigation.

Content of Audit Documentation

Audit documentation is the principal record of the audit. Because audit documentation provides the principal support for the representations in the auditor's report, it should: - Demonstrate how the audit complied with auditing and related professional practice standards. - Support the basis for the auditor's conclusions concerning each material financial statement assertion. - Demonstrate that the underlying accounting records agreed or reconciled with the financial statements. Audit documentation should include an audit program (or set of audit programs) for the engagement. The audit program should set forth in reasonable detail the auditing procedures that the auditor believed necessary to accomplish the objectives of the audit. Audit documentation should be sufficient to show that standards of fieldwork have been followed Audit documentation should enable a reviewer with relevant knowledge and experience to: - Understand the nature, timing, extent, and results of the procedures performed, evidence obtained, and conclusions reached. - Determine who performed the work and the date such work was completed, as well as the person who reviewed the work and the date of such review

Ownership of Audit Documentation

Audit documentation is the property of the auditor. This includes not only audit documents prepared by the auditor but also documents prepared by the entity at the request of the auditor. The auditor should retain audit documents for a reasonable period of time in order to meet the needs of his or her practice and legal record retention requirements. Although the auditor owns the audit documents, they cannot be shown, except under certain circumstances, to outside parties without the entity's consent. The Sarbanes-Oxley Act and the PCAOB standards require that audit documentation be retained for seven years from the date of completion of the engagement, as indicated by the date of the auditor's report (or the date that fieldwork is substantially completed), unless a longer period of time is required by law (e.g., in cases involving pending or threatened lawsuit, investigation, or subpoena). All documents that "form the basis of the audit or review" are required to be retained. Prior to Sarbanes, public accounting firms would not typically include in their working papers documentation that was inconsistent with the final conclusion of the audit team regarding a matter, nor would they include all internal correspondence leading up to a final decision. PCAOB standards also require that any document created, sent, or received, including documents that are inconsistent with a final conclusion, be included in the audit files for all significant matters

Functions of Audit Documentation

Audit documentation is the record of audit procedures performed, relevant audit evidence obtained, and conclusions the auditor reached. Audit documentation is also referred to as working papers or the audit file. You can think of audit documentation as the "story" of the audit. Audit documentation has three functions: (1) to provide principal support for the representation in the auditor's report that the audit was conducted in accordance with GAAS; (2) to aid in the planning, performance, and supervision of the audit; and (3) to provide the basis for the review of the quality of the work by providing a written documentation of the evidence supporting the auditor's significant conclusions. The form and content of the audit documentation are a function of the circumstances of the specific engagement.

Audit Procedures for Obtaining Audit Evidence

Audit procedures are specific acts performed by the auditor to gather evidence about whether specific assertions are being met. As discussed in Chapter 3, there are three categories of audit procedures. Each serves the following purposes:

The Relationship of Audit Evidence to the Audit Report

Auditing standards provide the basic framework for the auditor's understanding of audit evidence and its use in supporting the auditor's opinion on the financial statements. The auditor gathers evidence by conducting audit procedures to test management assertions. Chapter 3 covers the types of audit procedures used to gather evidence. This evidence serves as the support for the auditor's opinion about whether the financial statements are fairly presented. Figure 5-1 presents an overview of the relationships among the financial statements, management assertions about components of the financial statements, audit procedures, and the audit report. More specifically, the financial statements reflect management's assertions about the various financial statement components. The auditor tests management's assertions by conducting audit procedures that provide evidence on whether each relevant management assertion is supported. When the evidence supports management's assertions, the auditor can issue an unqualified audit report

Corroboration

Auditors must corroborate explanations for unexpected differences by obtaining sufficient appropriate audit evidence linking the explanation to the difference and substantiating that the information supporting the explanation is reliable. This evidence should be of the same quality as the evidence obtained to support tests of details. Such evidence could vary from simply comparing the explanation to the auditor's knowledge from other areas, to employing other detailed tests to confirm or refute the explanation. Common corroborating procedures include examination of supporting evidence, inquiries of independent persons, and evaluating evidence obtained from other auditing procedures.

Tick Marks

Auditors use tick marks to document work performed. Tick marks are simply notations that are made by the auditor near, or next to, an item or amount on an audit document. The tick mark symbol is typically explained or defined at the bottom of the audit document, although many firms use a standard set of tick marks. Exhibit 5-2 shows some examples of tick marks. In this example of documentation, the tick mark "V" indicates that the auditor examined the bills sent to the entity by the payee for proper amount and description

Assertions about Classes of Transactions and Events, and Related Disclosures, for the Period under Audit

Below (not counting classification and presentation)

Coverage Ratios

Coverage ratios provide information on the long-term solvency of the entity. These ratios give the auditor important information on the ability of the entity to continue as a going concern.

Current Ratio

Current Assets / Current Liabilities It includes all current assets and current liabilities and is usually considered acceptable if it is 2 to 1 or better. Generally, a high current ratio indicates an entity's ability to pay current obligations. However, if current assets include old accounts receivable or obsolete inventory, this ratio can be distorted.

An "Assurance Bucket" Analogy

Figure 5-4 illustrates what we call the "assurance bucket." The assurance bucket must be filled with sufficient appropriate evidence to obtain the level of assurance necessary to support the auditor's opinion. Following the top-down audit testing hierarchy means that the auditor first begins to fill the bucket with evidence from the risk assessment procedures. In Figure 5-4, after completing risk assessment procedures, the auditor sees that the assurance bucket for a particular account and assertion is about 20 percent full. The auditor would next conduct control testing. In our example, control testing might add about another 30 percent to the bucket. How would the auditor know just how full the bucket is after testing controls? This is clearly a very subjective evaluation, and it is a matter of professional judgment. The auditor next performs substantive analytical procedures and adds the assurance gained from these procedures to the bucket. In Figure 5-4 the bucket is now about 70 percent full. In this illustration, the auditor would need to top off the assurance bucket with evidence obtained through tests of details. For lower-risk, well-controlled accounts, the assurance bucket may be entirely filled with tests of controls and substantive analytical procedures. For other accounts or assertions, the bucket may be filled primarily with tests of details. The size of the assurance bucket can vary, depending on the auditor's risk assessment and the assertion being tested. Obviously, certain assertions will be more important or present greater risks for some accounts than for others. For instance, existence (or validity) is typically more important for accounts receivable than it is for accounts payable. After the auditor has determined the risks associated with the assertions for an account balance, the auditor can determine the size of the assurance buckets (i.e., how much assurance is needed) and then begin filling the buckets by applying the audit testing hierarchy. Figure 5-5 illustrates these concepts for accounts payable. Note that the largest bucket is for the completeness assertion, because with liability accounts the auditor is primarily concerned with potential understatement errors; that is, unrecorded liabilities. The example in Figure 5-5 also illustrates that some assertions may be filled entirely with tests of details (e.g.. rights and obligations) and that others may not require any tests of details (e.g., existence). Again, these are subjective matters that require considerable professional judgment

Applying the audit testing hierarchy is more efficient.

Generally, tests of controls and substantive analytical procedures are less costly to perform than are tests of details. This is usually because tests of controls and substantive analytical procedures provide assurance on multiple transactions. In other words, by testing controls and related processes, the auditor generally gains a degree of assurance over thousands or even millions of transactions. Furthermore, substantive analytical procedures often provide evidence related to more than one assertion and often more than one balance or class of transactions. On the other hand, tests of details often only obtain assurance related to one or two specific assertions pertaining to the specific transaction(s) or balance tested. Auditing standards require that auditors perform substantive procedures for significant account balances and classes of transactions regardless of the assessed risk of material misstatement. In other words, assurance obtained solely from testing controls is not sufficient for significant balances and classes of transactions.

Inquiry

Inquiry consists of seeking information of knowledgeable persons (both financial and nonfinancial) within the entity or outside the entity. Inquiry is an important audit procedure that is used extensively throughout the audit and often is complementary to performing other audit procedures. For example, much of the audit work conducted to understand the entity and its environment including internal control involves inquiry. 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. The reliability of audit evidence obtained from responses to inquiries is also affected by the training, knowledge, and experience of the auditor performing the inquiry, because the auditor analyzes and assesses responses while performing the inquiry and refines subsequent inquiries according to the circumstances. In some cases, the nature of the response may be so significant that the auditor requests a written representation from the source

Inspection of Tangible Assets

Inspection of tangible assets consists of physical examination of the assets. Inspection is a relatively reliable type of evidence that involves the auditor inspecting or counting a tangible asset. An audit engagement includes many situations in which the auditor physically examines an entity's assets. Some examples might be counting cash on hand, examining inventory or marketable securities, and examining tangible fixed assets. This type of evidence primarily provides assurance that the asset exists. In some instances, such as examining inventory, physical examination may provide evidence on valuation by identifying items that are obsolete or slow-moving. However, physical examination provides little or no assurance for the rights and obligations assertion

Management Assertions

Management is responsible for the fair presentation of the financial statements. In representing that the financial statements are in accordance with the applicable financial reporting framework, management implicitly or explicitly makes assertions regarding recognition, measurement, and presentation of classes of transactions and events, account balances, and disclosures. For example, when the balance sheet contains a line item for accounts receivable of $5 million, management asserts that those receivables exist and have a net realizable value of $5 million. Management also asserts that the accounts receivable balance arose from selling goods or services on credit in the normal course of business. Stop and Think: Take a moment and consider what the relevant management assertions are when the financial statements show a net sales amount of $100 million. Under current auditing standards, management assertions fall into the following two categories: 1.) Assertions about classes of transactions and events, and related disclosures, for the period under audit 2.) Assertions about account balances, and related disclosures, at the period end

Observation

Observation consists of looking at a process or procedure being performed by others. The actions being observed typically do not leave an audit trail that can be tested by examining records or documents. Examples include observation of the performance of control activities and the observation of the counting of inventories by the entity's personnel. 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. It is also limited by the fact that the entity's personnel may act differently when the auditor is not observing them. Observation is useful in helping auditors understand the entity's processes but is generally not considered very reliable and thus generally requires additional corroboration by the auditor

Quantification

Quantification involves determining whether the explanation or error can explain the observed difference. While it may not be possible to quantify the exact amount of a difference between an analytical procedure's expectation and the entity's recorded amount, the auditor should quantify the portion of the difference that can be explained. This may require the recalculation of the expectation after considering the additional information. For example, an entity employee may offer the explanation that the significant increase in inventory over the prior year is due to a 12 percent increase in raw materials prices. The auditor should compute the effects of the raw materials price increase and determine the extent to which the price increase explains (or does not explain) the increase in the overall inventory account.

Recalculation

Recalculation consists of checking the mathematical accuracy of documents or records. Recalculation can be performed manually or through the use of information technology (e.g., by obtaining an electronic file from the entity and using computer assisted audit techniques or audit data analytics, to check the accuracy of the summarization of the file). Specific examples of this type of procedure include recalculation of depreciation expense on fixed assets and recalculation of accrued interest. Recalculation also includes footing, cross footing, reconciling subsidiary ledgers to account balances, and testing postings from journals to ledgers. Because the auditor creates this type of evidence, it is normally viewed as highly reliable.

Reperformance

Reperformance involves the independent execution by the auditor of procedures or controls that were originally performed by company personnel. For example, the auditor may reperform the aging of accounts receivable. Again, because the auditor creates this type of evidence, it is normally viewed as highly reliable.

Scanning

Scanning is the auditor's exercise of professional judgment to review accounting data to identify significant or unusual items to test. This includes searching for large and unusual items in the accounting records (cg., nonstandard journal entries), as well as reviewing transaction data (e.g., expense accounts, adjusting journal entries) for indications of errors that have occurred. It might be used in conjunction with analytical procedures but also as a stand-alone procedure. Scanning can be performed either manually or through the use of CAATS.

Short-Term Liquidity Ratios

Short-term liquidity ratios indicate the entity's ability to meet its current obligations. Three ratios commonly used for this purpose are the current ratio, the quick ratio, and the operating cash flow ratio.

The Sufficiency and Appropriateness of Audit Evidence

Sufficiency is the measure of the quantity of audit evidence. Appropriateness is a measure of the quality of audit evidence. Sufficiency and appropriateness of audit evidence are interrelated. The auditor must consider both concepts when assessing risks and designing audit procedures. The quantity of audit evidence needed is affected by the risk of material misstatement and by the quality of the audit evidence gathered. Thus, the greater the risk of material misstatement, the more audit evidence is likely to be required to meet the audit test. And the higher the quality of the evidence, the less evidence that may be required to meet the audit test. Accordingly, there is an inverse relationship between the sufficiency and appropriateness of audit evidence.

Reliability of the Types of Evidence

Table 5-6 presents a hierarchy of the reliability of the types of evidence. Refer to the earlier discussion about the relevance and reliability of evidence to help you understand the distinctions being made here. Inspection of tangible assets, reperformance, and recalculation are generally considered of high reliability because the auditor has direct knowledge about them. Inspection of records and documents, confirmation, analytical procedures, and scanning are generally considered to be of medium reliability. The reliability of inspection of records and documents depends primarily on whether a document is internal or external, and the reliability of confirmation is affected by the four factors listed previously. The reliability of analytical procedures may be affected by the availability and reliability of the data. Finally, observation and inquiry are generally low-reliability types of evidence because both require further corroboration by the auditor

The Evaluation of Audit Evidence

The ability to evaluate evidence appropriately is another important skill an auditor must develop. Proper evaluation of evidence requires that the auditor understand the types of evidence that are available and their relative reliability or diagnosticity. The auditor must be capable of assessing when a sufficient amount of appropriate evidence has been obtained in order to determine the fairness of management's assertions. In evaluating evidence, an auditor should be thorough in searching for evidence and unbiased in its evaluation. For example, suppose an auditor decides to mail accounts receivable confirmations to 50 of the largest customers of an entity that has a total of 5,000 customer accounts receivable. Even if some of the 50 customers do not respond directly to the auditor, the auditor must gather sufficient evidence on each of the 50 accounts, which could include searching for subsequent cash receipts, shipping documents, invoices, and so forth. In evaluating evidence, the auditor must remain objective and must not allow the evaluation of the evidence to be biased by other considerations. To illustrate, in evaluating a credit manager's response to an audit inquiry, the auditor must not allow any personal factors (e.g., the credit manager is likeable and friendly) to influence the evaluation of the response

Accuracy

The accuracy assertion addresses whether amounts and other data relating to recorded transactions and events have been recorded appropriately, and related disclosures have been appropriately measured and described. Generally accepted accounting principles establish the appropriate method for recording a transaction or event. For example, the amount recorded for the cost of a new machine includes its purchase price plus all reasonable costs to install it.

Existence

The assertion about existence addresses whether ending balances of assets, liabilities, and equity interests included in the financial statements actually exist at the date of the financial statements. For example, management asserts that inventory shown on the balance sheet exists and is available for sale.

Organization of Audit Documentation

The audit documentation needs to be organized so that any member of the audit team (and reviewers) can find the audit evidence that supports each financial statement account. While auditing standards do not dictate how this should be accomplished, the following discussion presents a general approach that is commonly used. The financial statements contain the accounts and amounts covered by the auditor's report. These accounts come from the working trial balance, which summarizes the general ledger accounts contained on each lead schedule. Each lead schedule includes the general ledger accounts that make up the financial statement account. Different types of audit documentation (account analysis, listings, confirmations, and so on) are then used to support each of the general ledger accounts. Each of these audit documents is indexed, and all important amounts are cross-referenced between audit documents. Figure 5-6 presents an example of how audit documents could be organized to support the cash account. Note that the $15,000 shown on the balance sheet agrees to the working trial balance. The "A lead" schedule in turn contains the three general ledger accounts that are included in the $15,000 balance. Audit documents then support each of the general ledger accounts

Indexing and Cross-Referencing

The audit documents must be organized so that members of the audit team or firm can find relevant audit evidence. Some firms use a lettering system; other firms use some type of numbering system. For example, the general working papers may be labeled "A," internal control systems working papers "B," cash working papers "C," and so on. When the auditor performs audit work on one working paper and supporting information is obtained from another working paper, the auditor cross-references (it can be "linked" in audit software) the information on each working paper. This process of indexing and cross-referencing provides a trail from the financial statements to the individual audit documents that a reviewer can easily follow. Indexing and cross-referencing are discussed further in the next section.

Audit Plan and Programs

The audit plan contains the strategy to be followed by the auditor in conducting the audit. This document outlines the auditor's understanding of the entity and the potential audit risks. It contains the basic framework for how the audit resources (budgeted audit hours) are to be allocated to various parts of the engagement. The audit programs contain the audit procedures that will be conducted by the auditor. Generally, each business process and account balance has a separate audit program.

Applying the audit testing hierarchy is more effective

The auditor's understanding and testing of controls influence the scope (nature, timing, and extent) of substantive testing and enhance the auditor's ability to hone in on areas where misstatements are more likely to be found. If controls are highly effective, less extensive substantive procedures (i.e substantive analytical procedures and tests of details) will need to be performed. Similarly, substantive analytical procedures can direct attention to higher-risk areas where the auditor can design and conduct focused tests of details.

Authorization

The authorization assertion relates to whether all transactions have been properly authorized. For example, the purchase of a new manufacturing facility should be approved by the board of directors.

Completeness

The completeness assertion relates to whether all transactions and events that should have been recorded and all related disclosures that should have been included in the financial statements have been included. For example, if an entity fails to record a valid revenue transaction, the revenue account will be understated.

Cutoff

The cutoff assertion relates to whether transactions and events have been recorded in the correct accounting period. For example, the auditor may want to test proper cutoff of revenue transactions at December 31, 2018. The auditor can examine a sample of shipping documents and sales invoices for a few days before and after year-end to test whether the sales transactions are recorded in the proper period. The objective is to determine that all 2018 sales and no 2019 sales have been recorded in 2018. Thus, the auditor examines the shipping documents to ensure that no 2019 sales have been recorded in 2018 and that no 2018 sales are recorded in 2019

Develop an Expectation

The first step in the decision process is to develop an expectation for the amount or account balance. This is the most important step in performing analytical procedures. Auditing standards require the auditor to have an expectation whenever analytical procedures are used. An expectation can be developed for an analytical procedure from a variety of sources, such as - Financial and operating data. - Budgets and forecasts. - Industry publications. - .Competitor information. - Management's analyses. - Analysts reports. The quality of an expectation is referred to as the precision of the expectation. Precision is a measure of the potential effectiveness of an analytical procedure; it represents the degree of reliance that can be placed on the procedure. Precision is a measure of how closely the expectation approximates the "correct" but unknown amount. The degree of desired precision will differ with the specific purpose of the analytical procedure. The precision of the expectation is a function of the materiality and required detection risk for the assertion being tested. If the assertion being tested requires a low level of detection risk, the expectation needs to be very precise. However, the more precise the expectation, the more extensive and expensive the audit procedures used to develop the expectation, which results in a cost-benefit trade-off.

Investigate Differences Greater Than the Tolerable Difference

The fourth step in the analytical procedures decision process (Figure 5-7) is the investigation of significant differences. Differences identified by substantive analytical procedures indicate an increased likelihood of misstatements. The more precise the expectation, the greater the likelihood that the difference is actually a misstatement. Inquiry of the entity's personnel is frequently an important aspect of the investigation of differences. Nevertheless, inquiry of the entity's personnel should not be the sole support for an explanation without quantification and corroboration (discussed below). There are four possible causes of significant differences-accounting changes, economic conditions or events, error, and fraud. Explanations for significant differences observed for substantive analytical procedures must be followed up and resolved through quantification, corroboration, and evaluation.

Gross Profit Percentage

The gross profit percentage ratio is generally a good indicator of potential misstatements and is calculated as follows: Gross Profit / Net Sales If this ratio varies significantly from previous years or differs significantly from industry data, the entity's financial data may contain errors. Numerous errors can affect this ratio. For example. if the entity has failed to record sales, the gross profit percentage will be less than in previous years. Similarly, any errors that affect the inventory account can distort this ratio. For example, if the entity has omitted goods from the ending inventory, this ratio will be smaller than in previous years.

Evaluation

The key mind-set behind effectively performing substantive analytical procedures is one of appropriate professional skepticism, and obtaining a sufficient amount of appropriate audit evidence. The auditor should evaluate the results of the substantive analytical procedures to conclude whether the desired level of assurance has been achieved. If the auditor obtains evidence that a misstatement exists and can be sufficiently quantified, the auditor makes note of his or her proposed adjustment to the entity's financial statements. If the auditor concludes that the substantive analytical procedure performed did not provide the desired level of assurance, tests of details should be performed to achieve the desired assurance.

Disaggregation

The more detailed the level at which an expectation is formed, the greater the precision. For example, expectations formed using monthly data will be more precise than expectations formed using annual data. Analytical procedures conducted to provide substantive evidence normally cannot be performed at aggregated levels (e.g., annual data, total revenues). Misstatements are difficult to detect when analyzing data at aggregate levels, due to offsetting trends or activities that can mask risks and misstatements. Examples later in the chapter illustrate this concept.

The Nature of Audit Evidence

The nature of the evidence refers to the form or type of information, which includes accounting records and other available information. Accounting records include the records of initial entries and supporting records, such as checks and records of electronic fund transfers: invoices; contracts; the general and subsidiary ledgers, journal entries, and other adjustments to the financial statements that are not reflected in formal journal entries; and records such as work sheets and spreadsheets supporting cost allocations. computations, reconciliations, and disclosures. Other information that the auditor may use as audit evidence includes minutes of meetings; confirmations from third parties; industry 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

Occurrence

The occurrence assertion relates to whether all recorded or disclosed transactions and events have occurred and pertain to the entity. For example, management asserts that all revenue transactions recorded during the period were valid transactions. The occurrence assertion is relevant for revenue transactions because the entity's personnel might have incentives to record fictitious transactions. Occurrence is sometimes referred to as validity

The Plausibility and Predictability of the Relationship Being Studied

The primary concern with plausibility is simply whether the relationship used to test the assertion makes sense. For example, it is usually plausible to expect that an increase in sales should lead to an increase in accounts receivable. Many factors, including changes in the business or industry, influence the predictability of relationships among financial and nonfinancial data.

Define a Tolerable Difference

The second step in the analytical procedures decision process (see Figure 5-7) is to define a tolerable difference. The size of the tolerable difference depends on the significance of the account, the desired degree of reliance on the substantive analytical procedure, the level of disaggregation in the amount being tested, and the precision of the expectation. The amount of difference that can be tolerated will generally always be lower than tolerable misstatement, and when testing an entire account with a substantive analytical procedure, tolerable difference will usually be equal to the account's tolerable misstatement. Sometimes. to achieve the desired level of assurance with a substantive analytical procedure, the auditor will use a tolerable difference that is less than tolerable misstatement for the account. In these instances, the auditor may use a rule of thumb such as "tolerable difference is 5 percent of the entity's recorded amount, but not to exceed tolerable misstatement."

Type of Analytical Procedure Used to Form an Expectation

The three types of analytical procedures discussed earlier (trend, ratio, and reasonableness analysis) represent different ways to form an expectation. In general, trend analysis is the least precise method used and reasonableness analysis is the most precise. All three types are used for substantive analytical procedures, but reasonableness analysis is not commonly used for preliminary or final analytical procedures

The Investigation of Differences for Analytical Procedures Used as Risk Assessment Procedures (Planning) and as Final Analytical Procedures

The way in which differences are investigated diverges in important ways for planning and final analytical procedures. At planning, the auditor is not required to obtain corroborative evidence because planning analytical procedures are not intended to provide substantive audit evidence regarding specific assertions. Rather, the auditor normally determines whether the planned audit procedures need to be revised in light of the results of preliminary analytical procedures. For example, to address the increased risk posed by the spike in inventory, the auditor may decide to expand the number of items tested during the observation of the year-end physical inventory count (see I Figure 5-3) When conducting final analytical procedures, the auditor investigates unexpected differences by first going to the working papers to determine if sufficient appropriate evidence has already been gathered to explain the difference (rather than going to the entity's personnel for an explanation). If the auditor cannot find sufficient evidence within the working papers, then the auditor would formulate possible explanations, conduct additional testing, and seek an explanation from the entity's personnel

Relationships among Elements of Financial Information within the Current Period.

There are many examples of one element in the financial statements directly relating to another element. This is particularly true for the association between certain balance sheet accounts and their related income or expensed accounts. In these situations, reasonableness analysis is typically used to model the association.

Comparison of Current-Year Financial Information with Comparable Prior Period(s) after Consideration of Known Changes.

This is perhaps the most commonly used analytical procedure. The comparison of financial statement amounts can be done using absolute amounts (i.e., trend analysis) or by converting the financial statement amounts to "common-size" financial statements (ratio analysis). Exhibit 5-4 presents an example of a common-size income statement for Earth Wear for 2018-2016. An auditor may compare the amounts shown for the three years and investigate those amounts that are out of line by some predetermined cutoff percentage or absolute amount.

Comparison of Current-Year Financial Information with Budgets, Projections, and Forecasts.

This technique is usually performed using trend analysis and is similar to the previous example except that the current- year budget, projection, or forecast represents the expectation (rather than the expectation being provided by prior-year data). For example, the auditor can test the fairness of advertising expense by comparing the current-year amount to the entity's budget and investigating differences.

Substantive procedures

Used to detect material misstatements at the relevant assertion level. Substantive procedures include tests of details and substantive analytical procedures.

Risk assessment procedures

Used to 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 relevant assertion levels.

Tests of controls

Used to test the operating effectiveness of controls in preventing, or detecting and correcting material misstatements at the relevant assertion level. Tests of controls are discussed in more detail in Chapter 6.