1. Audit Evidence and Documentation Chapter 5

2. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-2 Management Assertions Existence or Occurrence--Assets, liabilities, and owners’ equity accounts reflected in the financial statements exist; the recorded transactions have occurred. Completeness--All transactions, assets, liabilities, and elements of owners’ equity that should be presented in the financial statements are included. Rights and Obligations--The client has rights to assets and obligations to pay liabilities that are included in the financial statements. Valuation or Allocation--Assets, liabilities, owners’ equity, revenues, and expenses are presented at amounts that are determined in accordance with generally accepted accounting principles. Presentation and Disclosure--Accounts are described and classified in the financial statements in accordance with generally accepted accounting principles, and all material disclosures are provided.

3. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-3 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.

4. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-4 Audit Risk Formula AR = IR * CR * DR AR = Audit risk IR = Inherent risk CR = Control risk DR = Detection risk

5. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-5 Audit Risk

6. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-6 Competence of Evidential Matter To be competent evidence must be: Valid Relevant Principles Independent sources have greater reliability than those within the client organization. Strong internal control increases reliability of evidence created within the client organization. Directly obtained evidence is more reliable than evidence obtained second hand.

7. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-7 Reliability of Certain Types of Audit Evidence RELIABILITYTYPEEXAMPLE HighPhysicalInventory Observation Documentary ExternalCutoff Bank Statement External/InternalPurchase Invoice InternalSales Invoice LowClient RepresentationsManagement Representation Letter

8. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-8 Types of Evidence Accounting information system Documentary evidence Third-party representations Physical evidence Computations Data interrelationships Client representations

9. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-9 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

10. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-10 Identifying Potential Misstatements

11. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-11 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.

12. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-12 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

13. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-13 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

14. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-14 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

15. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-15 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

16. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-16 Types of Working Files Current files Permanent files

17. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-17

18. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-18