Audit Evidence and Documentation Chapter 5

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-2 Financial Statement Assertions  Assertions about account balances (Accounts)  Assertions about classes of transactions and events (Transactions)  Assertions about presentation and disclosure (Disclosures)

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-3 Financial Statement Assertions AccountsTransactionsDisclosures ExistenceOccurrence Rights and obligations Completeness Valuation and allocation AccuracyAccuracy and valuation Cutoff ClassificationClassification and understandability

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-4 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

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-5 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.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-6 Audit Risk Formula AR = IR * CR * DR AR = Audit risk IR = Inherent risk CR = Control risk DR = Detection risk

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-7 Audit Risk

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-8 The Third Field Work Standard  Third standard of field work: The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to perform a reasonable basis for an opinion regarding the financial statements under audit  Sufficient audit evidence The quantity of audit evidence that must be obtained

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-9 Appropriateness of 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

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Reliability of Certain Types of Audit Evidence RELIABILITYTYPEEXAMPLE HighPhysicalInventory Observation Documentary ExternalCutoff Bank Statement External/InternalPurchase Invoice InternalSales Invoice LowClient RepresentationsManagement Representation Letter

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Types of Audit Evidence  Accounting information system  Documentary evidence  Third-party representations  Physical evidence  Computations  Data interrelationships  Client representations

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved 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  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

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Audit Procedures  Accounting information system  Documentary evidence Tracing Vouching Inspection Reconciliations  Third-party representations--Confirmation  Physical examination  Computations—Reperformance  Data interrelationships—Analytical procedures  Client representations Inquiries Letters of representations

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Analytical Procedures--I  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  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.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Analytical Procedures--II  Categories of ratios Liquidity (e.g., current ratio) Leverage (e.g., debt to equity) Profitability (e.g., gross profit percentage) Activity (e.g., inventory turnover)  Basic approaches Horizontal analysis—analyze ratios of a company 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

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Identifying Potential Misstatements

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved 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.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Auditing Fair Values  If the item is traded on an organized market, fair value may be obtained from market prices  If the item does not trade on an organized market determine fair value by: Analyzing to a similar market is possible Using a valuation model

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved 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

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved 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

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved 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

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Types of Working Files  Current files  Permanent files

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-23

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Preparation of a Working Paper – Figure 5.8