Rittenberg/Schwieger/Johnstone Auditing: A Business Risk Approach Sixth Edition Chapter 5

1. Rittenberg/Schwieger/JohnstoneAuditing: A Business Risk ApproachSixth EditionChapter 5 Audit Evidence: A Framework

2. Overview Auditing is a process of objectively gathering, evaluating, and documenting the evidence needed to provide assurance on the financial statements In planning an audit, three questions need to be answered: • What audit procedures should be performed? • How much evidence is needed? • When should the audit procedures be performed? The audit programs detail the auditor's plan to gather, evaluate, and document evidence

3. Overview (continued) The evidence gathering process is the core of the audit; evidence is needed to • Reduce audit risk • Support the opinion In deciding which evidence to gather, the auditor considers • Risk associated with an account balance or other measures of performance • Types of evidence available • Reliability of alternative sources of evidence

4. Third Standard of Fieldwork Sufficient, competent evidential matter is to be obtained through audit procedures performed to afford a reasonable basis for an opinion regarding the financial statements under audit

5. What is the assertion model? • The auditor gathers evidence to evaluate the management assertions embodied in the financial statements and individual accounts • Existence or occurrence • Completeness • Rights and obligations • Valuation or allocation • Presentation and disclosure

6. Gathering Sufficient, Competent Evidence Because each audit is unique, there is no set amount or type of evidence that must be gathered When considering the best approach to gather evidence, the auditor needs to consider factors affecting the reliability of the financial data: • Management integrity • Client economic risk • Quality of client's information system • Client's control structure • Current market conditions and competitor actions

7. The Steps in the OverallAudit Process 1. Understand the client and industry 2. Assess environment risk 3. Directly test transactions and/or account balances 4. Assess adequacy of evidence

8. Sufficient, Competent Evidence There are two dimensions to audit evidence: sufficient (quantity) and competent (quality/reliability) The relationship between these dimensions is inverse: if evidence is of lesser quality, greater amounts must be collected (and vice versa) When gathering evidence, auditors consider which procedures provide the most reliable evidence in the most efficient manner Reliability depends on the circumstances under which evidence is gathered: • Evidence obtained from independent outside sources is more reliable than evidence obtained from the client • Evidence obtained from auditor's direct knowledge is more reliable than evidence obtained indirectly • Evidence obtained from client with strong internal controls is more reliable than evidence obtained from client with weak internal controls

9. Internal Documentation Reliability varies with • Quality of client's internal controls • Management's motivation to misstate (fraud potential) • Formality of the documentation including acknowledgement by independent parties • Preparation of the document independently of the accounting system and management

10. External Documentation • Generally considered highly reliable • External documents provided by a client should be viewed more critically than documents received directly from the external party

11. Paper vs. Electronic Documentation Major challenge for auditors to determine which electronic data is reliable Computer systems can be designed to provide safeguards similar to paper-based systems If auditor is going to rely on electronic data, he/she must develop an understanding of the • Client's computer system • Controls used to safeguard electronic data from manipulation or destruction

12. The Nature of Audit Testing When directly testing an account balance or transactions, the auditor examines two basic types of evidence • The underlying accounting data and records • Corroborating information that validates the underlying accounting data

13. The Nature of Audit Testing (continued) Auditors have traditionally used direct tests of year-end account balances, as opposed to examining the transactions that make up the account balance Generally, • There are usually fewer items in the ending balance than the number of underlying transactions during the year • More reliable evidence usually exists for an ending balance than for the underlying transaction

14. The Nature of Audit Testing (continued) However, for many long term accounts (assets, liabilities, owners' equity), the auditor may focus on the transactions that occurred during the audit period For these accounts, • There are usually fewer transactions during the year than items in the ending balance • Reliance forms of evidence are often available

15. Audit Procedures The procedures an auditor will use vary according to the risks associated with the client and the methods used to record transactions. Three major phases of the audit: • Preliminary planning and risk analysis • Understand and test system • Test account balances or other business measurements

16. Audit Procedures: Preliminary Planning and Risk Analysis • Review prior-year audit work • Review publicly available data about the organization • Perform analytical procedures • Inquire of management and employees

17. Audit Procedures: Understand and Test the System For all systems: • Inquire of management and employees • Review system documentation • Observe system in operation • Document system flow and control points • Select transactions and trace through processing Additional work for computerized systems: • Test important computer controls • Use computer software to trace transactions through system • Use software to select transactions for further verification

18. Audit Procedures: Test Account Balances or Other Business Measurements Direct tests of account balances: • Review authoritative records and documents • Examine client-retained documentation • Examine outside documentation • Examine electronic records Testimonial evidence: • Inquire of client personnel • Inquire of and analyze responses from outside parties

19. Audit Procedures: Test Account Balances or Other Business Measurements (continued) Auditor-generated evidence: • Direct observation • Perform re-computations • Reprocess transactions from source documents to accounting records • Vouch transactions from accounting records back to source documents • Physically examine assets • Perform analytical procedures Each of these procedures has strengths and weaknesses; the auditor's task is to determine which procedures provide a sufficient level of evidence with the least amount of audit cost

20. Directional Testing (Audit Efficiency) Directional testing: auditor tests for over- or understatement, not both Increases audit efficiency • Misstatements are more likely to occur in one direction (assets and revenues overstated, liabilities and expenses understated) • With directional testing, auditor uses procedures that focus on the most likely misstatements • Vouching and reprocessing are examples of directional tests • Can also provide evidence about complementary accounts • Some management assertions are directional by nature (existence addresses overstatement; completeness, understatement)

21. Evidence-gathering Procedures • Auditors use a variety of procedures to gather evidence • For certain accounts or management assertions, certain procedures may be more efficient or effective than other procedures • When writing audit programs, the auditor tries to use those procedures • The primary types of audit procedures include: • Observation of client personnel and procedures • Physical examination of assets • Inquiry • Confirmations • Examination of documents • Re-computation of data • Reprocessing transactions • Vouching transactions • Analytical procedures

22. Evidence-gathering Procedures (continued) Observation of client personnel and procedures • Most often used to gain an understanding of client processing system • Also used to observe counting of physical inventory • Limitations: • Intrusive and time-consuming • Employees know they're being watched and act differently; this makes it difficult to generalize the evidence obtained

23. Evidence-gathering Procedures (continued) Physical examination of assets • Useful in verifying existence of tangible assets • May be useful in identifying potential obsolescence or wear and tear • Does not provide evidence on completeness, ownership, or proper valuation (except as in item above)

24. Evidence-gathering Procedures (continued) Inquiry • Used extensively, especially early in the audit to gain an understanding • Efficient way to gather evidence • Not considered persuasive, should be corroborated by other sources of evidence Confirmations • Auditor sends letter to outside party asking them to verify client information • Considered strong evidence because they come from external parties • Limitations: • Respondents may not adequately check information being confirmed • Respondents may not respond in a timely fashion • Respondents may not challenge figures in their favor

25. Evidence-gathering Procedures (continued) Examination of documents • Much of the audit process involves examining documents • Useful for evaluating all of the assertions • Auditor should establish document authenticity in order to rely on it Recalculation • Includes footing, cross-footing, tests of extensions, re-computation • Often used to test accuracy of estimated accounts and allowances

26. Evidence-gathering Procedures (continued) Test of transactions involve reconciling source documents with recorded accounting information Reprocessing • Select sample of source documents and reprocess them to make sure they have all been properly recorded • Includes reviewing journalizing and posting of the transaction • Helps establish completeness (all valid items have been recorded)

27. Evidence-gathering Procedures (continued) Vouching • Reverse of reprocessing • Select sample of already recorded transactions and trace back to the underlying source documents • Helps establish that recorded transactions are valid (existence) Analytics • Compare recorded account balances (or ratios of balances) to expectations developed by the auditor • Sources used to develop these expectations include client's prior period information, industry data, expected results

28. Timing of Audit Procedures In addition to what procedures to perform, the auditor must also decide when to perform them • As of the balance sheet date • After the balance sheet date • Before the balance sheet date (interim testing) Advantages of interim testing: • Audit may be completed, and statements distributed, sooner • Typically means less overtime for audit staff

29. Timing of Audit Procedures (continued) Disadvantages of interim testing: • Risk of material misstatement between interim date and year-end Interim testing is feasible: • When client has strong internal controls • When there is low probability of significant change in account balances between interim work and year-end • For accounts in which the auditor focuses on tests of transactions rather than the year-end balance (example: non-current assets)

30. The Extent of Audit Procedures In addition to deciding what procedures to perform and when to perform them, the auditor must also decide how much evidence is needed The extent of testing is affected by: • Auditor's assessment of the risk of account balance misstatement • Amount of misstatement considered material • Persuasiveness of alternative forms of evidence The amount of evidence may also be influenced by the auditor's individual risk preferences

31. What are audit programs? (1) Audit programs specify the audit objectives and procedures used to gather, document, and evaluate evidence Audit programs guide the conduct of the audit and provide an effective means for: • Organizing and distributing audit work • Monitoring the audit process • Recording audit work performed • Reviewing the audit procedures performed and evidence gathered

32. What is documenting audit evidence? The audit work papers include all forms of documentation including: • Evidence of planning, including audit programs • The client's trial balance and any auditor adjustments • Copies of selected internal and external documents including confirmation and representation letters and abstracts of company documents • Schedules prepared or obtained by the auditor • Auditor memos • Results of analytical procedures and tests of client records • Auditor analysis of account balance

33. What are audit programs? (2) The work papers are the primary evidence in support of audit conclusions and should cover all relevant audit work, support the audit report, and leave no significant points unresolved The work papers aid in the conduct and supervision of the work, facilitate performance of an effective review, demonstrate adherence to professional and Firm auditing standards and procedures, and assist in planning the following year's audit

34. Characteristics of Good Audit Documentation Well-developed audit documentation contains: • A heading that includes client name, explanatory title, and balance sheet date • Initials of the auditor who prepared the documentation and date completed • Initials of the reviewer and date review completed • Description of the tests performed and the findings • Assessment of whether tests indicate material misstatement in an account • Tick marks and legend indicating work performed by the auditor • Index to identify the location of papers • Cross-reference to related documentation, when applicable

35. Importance of Quality Review • Audits of corporations subject to SEC regulation must be subjected to a concurring partner review before the audit report is issued • The concurring partner should not be involved in the audit, but should have knowledge of the client's business and industry