Chapter 7

Learning objective of chapter 7

7.1 contrast audit evidence with evidence used by other professions

7.2 identify the four audit evidence decisions that are needed to create an audit program

7.3 specify the characteristics that determine the persuasiveness of evidence

7.4 identify and apply the eight types of evidence used in auditing

7.5 know the types of analytical procedures and their purposes

7.7 compute common financial ratios

7.8 understand the purposes of audit documentation

7.9 prepare organized audit documentation

7.1 Contrast audit evidence with evidence used by other professions

Evidence

defined as any information used by the auditor to determine whether the information being audited is stated in accordance with the established criteria

Basis of comparison: use of the evidence

scientific experiment: determine effects of using the medicine

legal case: decide guilt or innocence of accused

audit: determine whether statements are fairly presented

Basis of comparison: nature of evidence used

scientific experiment: results of repeated experiments

legal case: direct evidence and testimony by witnesses and parties involved

audit: various types of audit evidence generated by the auditor, third parties, and the client

Basis of comparison: party or parties evaluating evidence

scientific experiment: scientist

legal case: jury and judge

audit: auditor

Basis of comparison: certainty of conclusion from evidence

scientific experiment: vary from uncertain to near certainty

legal case: requires guilt beyond a reasonable doubt

audit: high level of assurance

Basis of comparison: nature of conclusions

scientific experiment: recommend or not recommend use of medicine

legal case: innocence or guilt of party

audit: issue one of several alternative types of audit reports

Basis of comparison: typical consequences of incorrect conclusion from evidence

scientific experiment: society uses ineffective or harmful medicine

legal case: guilty party is not penalized or innocent party is found guilty

audit: statement users make incorrect decisions and auditor may be sued

7.2 Identify the four audit evidence decisions that are needed to create an audit program

Risk assessment procedures

help the auditor determine the relevant assertions for each material account balance, class of transactions, and disclosure

for each relevant assertion

the auditor identifies specific risks of material misstatement (ie. what could go wrong?)

Through business process (ie. transaction cycle) walkthroughs

the auditor identifies internal controls that have been implemented to mitigate the risks of material misstatement that the auditor has identified

Based on the results of tests of controls

the auditor determines that nature, extent, and timing of substantive audit evidence needed to provide assurance surrounding the identified risks of material misstatement

In determining the nature, extent, and time of evidence, auditors have 4 major decisions to make

• which audit procedures to use (nature)

• what sample size to select for a given procedure (extent)

• which items to select from the population (nature)

• when they perform the procedures (timing)

7.3 specify the characteristics that determine the persuasiveness of evidence

auditing standards require

that the auditor accumulate sufficient appropriate evidence to support the opinion that is issued

Because it would be prohibitively expensive to provide absolute assurance regarding the fair presentation of the financial statements (if absolute assurance could even be provided)

auditors must rely on persuasive (rather than conclusive) evidence to support their audit opinion

In order to be persuasive

audit evidence must be both sufficient and appropriate

Sufficiency of evidence

refers simply to the quantity of the evidence obtained

Most often, auditors do not examine 100% of the population of transactions under audit

but instead examine some sample of these transactions

The sufficiency of a sample size is influenced by

• the auditor’s expectation of misstatements

• the effectiveness of the client’s internal controls

The auditor’s expectation of misstatements

the greater the expectation of misstatement in an account balance, class of transactions, or disclosure, all else equal, the greater the required sample size

The effectiveness of the client’s internal controls

with effective internal controls, the audit can rely on internal controls to provide some assurance regarding the validity of particular assertions, and reduce the extent of substantive procedures (i.e. reduce the required sample size

Appropriateness of evidence depends on

• relevance

• reliability

• reliability

To be relevant

evidence must pertain to the specific assertion that is being tested

Reliability of evidence

is the degree to which the evidence can be trusted

There are 6 characteristics that determine the reliability of audit evidence

• independence of the provider

• effectiveness of the client’s internal controls

• auditor’s direct knowledge

• qualifications of individuals providing the information

• degree of objectivity

• timeliness

Independence of the provider

the more independent is the provider of the evidence, the more reliable the evidence is

Effectiveness of the client’s internal controls

the more effective a client’s internal controls, the more reliable the evidence obtained from accounting information systems with such internal controls in place

Auditor’s direct knowledge

first-hand knowledge is always more reliable than second-hand information

Qualifications of individuals providing the information

competence of those providing audit evidence is a necessary condition for the evidence to be reliable

Degree of objectivity

refers to the evidence itself. evidence that allows one to verify the validity of a particular assertion (e.g. physical count of inventory for the existence assertion) is more reliable than evidence that only allows one to evaluate the reasonableness of a particular assertion (e.g. observation of the inventory to look for obsolete items for the valuation assertion)

Timeliness

• evidence regarding assertions associated with balance sheet accounts is more reliable when it is obtained as close to the balance sheet date as possible

• evidence regarding assertions associated with income statement accounts is more reliable when it is obtained for a sample covering the entire period under audit, rather than a subset (quarters 1 or 2)

In order for audit evidence to be considered persuasive

it must be both appropriate (relevant and reliable) and sufficient (adequate sample size)

Auditors make trade-offs between

the persuasiveness of audit evidence and the cost of obtaining such evidence; however, cost alone is not a justification for falling to obtain persuasive (sufficient and appropriate) evidence

7.4 Identify and apply the eight types of evidence used in auditing

Every audit procedure obtains one or more of these 8 types of audit evidence

• physical examination (inspection of assets)

• confirmation

• inspection (inspection of documentation)

• analytical procedures

• inquiries of the client

• recalculation

• reperformance

• observation

Physical examination

• independence of provider: high (auditor)

• effectiveness of client’s internal controls: varies

• auditor’s direct knowledge: high

• qualification of provider: normally high (auditor)

• objectivity of evidence: high

Confirmation

independence of provider: high

effectiveness of client’s internal controls: not applicable

auditor’s direct knowledge: low

qualifications of provider: varies - usually high

objectivity of evidence: high

Inspection

independence of provider: varies - external documents more independent than internal documents

effectiveness of client’s internal controls: varies

auditor’s direct knowledge: low

qualification of provide: varies

objectivity of evidence: high

Analytical procedures

independence of provider: high/low (auditor does/client responds)

effectiveness of client’s internal controls: varies

auditor’s direct knowledge: low

qualifications of provider: normally high (auditor does/client responds)

objectivity of evidence: varies - depends on reliability of data

Inquiries of client

independence of provider: low (client provides)

effectiveness of client’s internal controls: not applicable

auditor’s direct knowledge: low

qualification of provider: varies

objectivity of evidence: varies - low to high

Recalculation

independence of provider: high (auditor)

effectiveness of client’s internal controls: varies

auditor’s direct knowledge: high

qualifications of provider: high (auditor)

objectivity of evidence: high

Reperformance

independence of provider: high (auditor)

effectiveness of client’s internal controls: varies

auditor’s direct knowledge: high

qualifications of provider: high (auditor)

objectivity of evidence: high

Observation

independence of provider: high (auditor)

effectiveness of client’s internal controls: varies

auditor’s direct knowledge: high

qualification of provider: normally high (auditor)

objectivity of evidence: medium

7.5 Know the types of analytical procedures and their purposes

Analytical procedures are defined by auditing standards as

as evaluations of financial information through analysis of plausible relationships among both financial and non-financial data

Analytical procedures are required

during both the planning and completion phases of the audit, but are also often utilized during the testing phase of the audit

The objective of analytical procedures differ

according to the phase of the audit in which these procedures are utilized

During the planning phase

analytical procedures are used as a diagnostic tool to assess risk and identify particular areas where additional audit effort is warranted

These analytical procedures typically

use data aggregated at a high level, such as overall financial statement balances

Example of analytical procedures in planning phase

observing unexpected significant fluctuations in financial statement account balances from the prior period to the current period in the unaudited trial balance for which a reasonable explanation is not readily apparent may indicate areas with a greater risk of material misstatement

During the completion phase

analytical procedures performed allow the auditor to take a final objective look at the audited financial statements, looking for any potential misstatements - identified by implausible relationships among financial statement account balances - that may have been missed during the prior phases of the audit

Analytical procedures can also be used during the testing phase

a substantive test with the objective of providing assurance surrounding particular financial statement assertion for a given account balance

Substantive analtical procedures

are confirmatory rather than exploratory in nature

substantive analytical procedures require the auditor to

• develop an expectation for an account balance

• test the controls around the production and maintenance of data used to develop this expectation (or otherwise test the completeness and accuracy of the underlying data)

• compare the expectation with the unaudited reported amount

• investigate any differences (greater than a clearly trivial threshold) between the expectation and the unaudited reported amount

In order to develop sufficiently precise expectations,

auditors typically use more disaggregated data for substantive analytical procedures than that used for analytical procedures during the planning and/or completion phases of the audit

Basic substantive analytical procedure hotel example

a basic substantive analytical procedure to develop a relatively precise expectation for lodging revenue for a hotel by multiplying the number of hotel rooms, the average daily rate for each room, and the average occupancy rate. the plausible relationship among these non-financial and financial data, should be able to predict lodging revenue for a given accounting period with reasonable precision

The auditor in the hotel example

the auditor must test the controls around the production and maintenance of these data inputs or otherwise test their completeness and accuracy, to be able to justify their use in the substantive analytical procedure

There are 4 broad classes of analytical procedures that may be used to compare client data with

• industry data

• similar prior-period data

• client-determined expected results

• auditor-determined expected results

Which analytical procedures are more likely to be used during the planning and completion phases of the audit

• industry data

• similar prior-period data

• client-determined expected results

Which analytical procedures are more likely to be used during the testing phase as a substantive test of account balances

auditor-determined expected results

7.7 Compute common financial ratios

Short-term debt-paying ability

• cash ratio

• quick ratio

• current ratio

Cash ratio

cash + marketable securities / current liabilities

Quick ratio

net accounts receivable / current liabilities

Current ratio

current assets / current liabilities

Liquidity activity ratios

• account receivable turnover

• days to collect receivable

• inventory turnover

• day to sell inventory

Account receivable turnover

nat sales / average gross receivables

Days to collect receivable

365 days / account receivable turnover

Inventory turnover

cost of goods sold / average inventory

Days to sell inventory

365 days / inventory turnover

Ability to meet long-term debt obligations

• debit to equity

• times interest earned

Debt to equity

total liabilities / total equity

Times interest earned

operating income / interest expense

Profitability ratios

• earnings per share

• gross profit percent

• profit margin

• return on assets

• return on common equity

Earnings per share

net income / average common shared outstanding

Gross profit percent

net sales - cost of goods sold / net sales

Profit margin

operating income / net sales

Return on assets

income before taxes / average total assets

Return on common equity

income before taxes - preferred dividends / average stockholders

7.8 Understand the purpose of audit documentation

Put broadly, audit documentation is the record of

• audit procedures performed

• relevant audit evidence obtained

• and

• the conclusions reached by the auditor

The information is contained

in a collection of files often referred to as working papers or workpapers

Usually workpapers are electronic files

but they can also be manual or hard copy documents

Audit documentation is generally

prepared by audit staff and audit seniors

Audit workpapers are

the property of the audit firm

Audit documentation allows

those reviewing the work performed (could be more senior members of the engagement team, internal or external inspectors, even jurors if the auditor were to be sued in court) to understand the procedures that the auditor performed and how the auditor came to a given conclusion

Audit documentation can also

be very helpful in assisting new members of the audit engagement team get up to speed on the client’s business processes and how audit testing was performed in prior years

Although prior year workpapers can be helpful

it is very important to auditors to resist the temptation to blindly perform what we call a SALY (same as last year) audit

A client’s processes and risk

can and do change year to year, and audit procedures that were appropriate previously may not be adequate for current year

For public company audits

after the audit engagement is complete, the audit documentation supporting the opinion that was issued must be retained for 7 years

For private company audits

the AICPA auditing standards require that audit documentation be retained for 5 years

After the audit report is released

the audit engagement team has a maximum of 45 days to finalize the audit documentation so that it can be archived

There are many

types of audit documentation

The foundation of a good audit

is a good audit plan

One of the first things that audit documentation helps with

is providing a clear articulation of the auditor’s risk assessment for each financial statement assertion for every material account balance or disclosure, and specific procedures (both tests of controls and substantive audit procedures - whether they are substantive analytical procedures or tests of details) that respond to identified risks of material misstatement

Other types of audit documentation include

the auditor’s understanding of internal control (which may be in the form of a narrative or a flowchart), as well as the record of the walkthroughs we conduct tracing selected transactions for significant business cycles from origination through recording in the general ledger

Permanent file documents

are going to be items of significance that will carry forward year to year, such as the articles of incorporation, and debt or lease agreements