Evidence and Documentation Chapter 5 Evidence and Documentation McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Management Assertions LO# 5 Management Assertions Financial statements issued by management contain explicit and implicit assertions. Table 5-1 2-2

Relationship of Audit Evidence to the Audit Report LO# 1 Relationship of Audit Evidence to the Audit Report Financial statements Audit report Management assertions about components of financial statements Auditor reaches a conclusion based on the evidence Audit procedures Provide evidence on the fairness of the financial statements 5-3

All the information, from LO# 3 Audit Evidence All the information, from whatever source, used by the auditor in arriving at the conclusions on which the audit opinion is based. 5-4

The Concepts of Audit Evidence LO# 3 The Concepts of Audit Evidence Nature of audit evidence Sufficiency and appropriateness of audit evidence Evaluation of audit evidence 5-5

Nature of Audit Evidence LO# 3 Nature of Audit Evidence Spreadsheets supporting cost allocations Records of initial entries and supporting records General and subsidiary ledgers Invoices Contracts Adjustments to financial statements Other computations, reconciliations, and disclosures Worksheets 5-6

Sufficiency of Audit Evidence LO# 3 Sufficiency of Audit Evidence Sufficiency is the measure of the quantity of audit evidence. Greater risk of misstatement requires a higher quantity of audit evidence. Higher quality audit evidence results in a lower quantity of audit evidence. 5-7

Appropriateness of Audit Evidence LO# 3 Appropriateness of Audit Evidence Relevance Appropriateness is a measure of the quality of audit evidence. Reliability Original documents Auditor’s direct personal knowledge Independent source of the evidence Effectiveness of internal control Documentary evidence 5-8

Evaluation of Audit Evidence LO# 3 Evaluation of Audit Evidence Proper evaluation of evidence requires an understanding of the: Relative reliability of available evidence. Types of evidence available. An auditor should be thorough in searching for evidence and unbiased in its evaluation. 5-9

LO# 4 Audit Procedures Specific acts performed by the auditor to gather evidence about whether specific assertions are being met. Risk assessment procedures Test of controls Substantive procedures 5-10

LO# 4 Audit Procedures A set of audit procedures prepared to test assertions for a component of the financial statements is referred to as an audit program. 5-11

Audit Procedures for Obtaining Audit Evidence LO# 4 Audit Procedures for Obtaining Audit Evidence Inspection of records and documents Evidence obtained from external documents is more reliable than evidence obtained from internal documents. Journal or Ledger Source Documents Vouching (Occurrence) Tracing (Completeness) 5-12

Audit Procedures for Obtaining Audit Evidence LO# 4 Audit Procedures for Obtaining Audit Evidence Inspection of tangible assets Physical examination of a tangible asset. The process of watching a process or procedure being performed by others. Observation 5-13

Audit Procedures for Obtaining Audit Evidence LO# 4 In conducting inquiry, the auditor should: Consider the knowledge, objectivity, experience, responsibility, and qualifications of the individual to be questioned. Ask clear, concise, and relevant questions. Use open or closed questions appropriately. Listen actively and effectively. Consider the reactions and responses, then ask follow-up questions. Evaluate the response. Inquiry 5-14

Audit Procedures for Obtaining Audit Evidence LO# 4 Audit Procedures for Obtaining Audit Evidence The process of obtaining a representation of information or of an existing condition directly from a third party. External Confirmation The reliability of evidence obtained through confirmations is directly 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. 5-15

Audit Procedures for Obtaining Audit Evidence LO# 4 Audit Procedures for Obtaining Audit Evidence External Confirmation 5-16 16

Audit Procedures for Obtaining Audit Evidence LO# 4 Audit Procedures for Obtaining Audit Evidence Recalculation Determining the mathematical accuracy of documents or records. The auditor’s independent execution of procedures or controls that were originally performed as part of the internal control system. Reperformance 5-17

Audit Procedures for Obtaining Audit Evidence LO# 4 Audit Procedures for Obtaining Audit Evidence Analytical procedures Evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data. Scanning Review of accounting data to identify significant or unusual items. 5-18

Reliability of Types of Evidence LO# 5 Reliability of Types of Evidence 5-19

Purposes of Analytical Procedures LO# 9 Purposes of Analytical Procedures Preliminary Analytical Procedures (Risk Assessment Procedures) Used to assist the auditor to better understand the business and to plan the nature, timing, and extent of audit procedures. Substantive Analytical Procedures Used to obtain evidential matter about particular assertions related to account balances or classes of transactions. Final Analytical Procedures Used as an overall review of the financial information in the final review stage of the audit. 5-20

Types of Analytical Procedures (See Table 5-10) LO# 9 Types of Analytical Procedures (See Table 5-10) Trend Analysis Ratio Analysis Reasonableness Analysis 5-21

LO# 9 Substantive Analytical Procedures Decision Process Figure 5-7 Overview of the Auditor’s Decision Process for Substantive Analytical Procedures 5-22

Develop an Expectation Auditing standards require the auditor to have an expectation whenever analytical procedures are used. An expectation can be developed using a variety of information sources such as: Financial and operating data. Budgets and forecasts. Industry publications. Competitor information. Management’s analyses. Analyst’s reports. 5-23

Define a Tolerable Difference LO# 9 The size of the tolerable difference depends on: the significance of the account; the desired degree of reliance on the substantive analytical procedures; the level of disaggregation in the amount being tested; and the precision of the expectation. But the amount is always less than planning materiality! 5-24

Compare and Investigate LO# 9 Compare and Investigate Compare the expectation to the recorded amount and investigate any differences greater than the tolerable difference. 5-25

LO# 9 Investigate Differences for Risk Assessment and Final Analytical Procedures Preliminary Analytical Procedures (Risk Assessment Procedures) Differences Final Analytical Procedures Differences Corroborating evidence is not required Corroborating evidence is required 5-26

Audit Testing Hierarchy Figure 5-3 Audit Testing Hierarchy: An Evidence Decision Process for Testing Significant Balances or Classes of Transactions LO# 6 5-27

Filling the Assurance Bucket LO# 6 Filling the Assurance Bucket 5-28

LO# 6 Example of Filling the Assurance Buckets for Each Assertion (Accounts Payable) 5-29

LO# 7 Audit Documentation The auditor’s principal record of the audit procedures performed, evidence obtained, and conclusions reached. Audit documentation (working papers) have two functions:  To provide support for the audit report.  To aid in the planning, performance, and supervision of the audit. 5-30

Content of Audit Documentation LO# 8 Content of Audit Documentation Audit documentation should: Demonstrate that the underlying accounting records agreed or reconciled with the financial statements. Support the basis for the auditor’s conclusions concerning each material financial statement assertion. Demonstrate how the audit complied with auditing and related professional practice standards. 5-31

Content of Audit Documentation LO# 8 Content of Audit Documentation Audit documentation should: Include a written audit program detailing auditing procedures necessary to accomplish audit objectives. Enable a knowledgeable and experienced reviewer to: Understand the nature, timing, extent, and results of audit procedures, evidence obtained, and conclusions reached. Determine who performed and reviewed the work, as well as the dates of the work and reviews. 5-32

Content of Audit Documentation LO# 8 Content of Audit Documentation Most public accounting firms maintain audit documentation in two types of files: Permanent files Current files Corporate charter Important contracts Chart of accounts Internal control documentation Organization chart Terms of stock and bond issues Accounting manual Prior years’ analytical procedures 5-33

Content of Audit Documentation LO# 8 Content of Audit Documentation Most public accounting firms maintain audit documentation in two types of files: Permanent files Current files Audit plan, audit report Adjusting journal entries Audit programs Reclassification journal entries Working trial balance Current financial statements Minutes of meetings Working papers supporting accounts 5-34

Format of Audit Documentation LO# 8 Heading (Exhibit 5-2, p. 153) Client name Title of the working paper Client’s year-end date Indexing and cross-referencing (Figure 5-6, p. 155) Notations that provide a trail from financial statements to audit documents. Tick marks (Exhibit 5-2, p. 153) Notations made next to work paper items indicating auditor/reviewer actions. 5-35

Audit Documentation Audit Plan Audit Program Working Trial Balance Overall strategy for audit (e.g. understanding client, risks, accounts, audit hours) Audit Program Audit procedures to be performed; for example, one program for each business process and/or account Working Trial Balance Exhibit 5-1 (p. 152) – adjustments ($ changes); reclassification (changes in classification of accounts) Account Analysis Exhibit 5-2 (p. 153) – activities in account Account Listing (Lead Schedule) Figure 5-6 (p. 155) – items left in ending balance Audit Memoranda Documents auditor’s work; e.g. errors identified, discussions with clients

Audit Documentation LO# 8 Audit documentation should be organized so that audit team members and others can find evidence supporting financial statement accounts. All audit documentation is the property of the auditor, including documents prepared by the client at the auditor’s request. The Sarbanes-Oxley Act of 2002 requires audit documentation to be retained for seven years from the completion date of the engagement. 5-37