AC 565 Midterm 2

Expected population deviation rate

Expected population deviation rate

Represents the exception rate the auditor expects to find in the population before testing begins

Audit Evidence

Represents the set of information the auditors gather and use to form their opinion

Audit Evidence: Information

obtained from (i) risk assessment (ii) test of controls (iii) substantive testing (iv) other audit procedures

Persuasiveness of Evidence

Auditors have to gather sufficient and appropriate evidence to support the auditors’ opinion

Determinants of persuasiveness of evidence

Sufficiency and appropriateness

Sufficiency of audit evidence:

Quantity of evidence gathered. It is measured by the sample size (substantive test and control tests). Items within a population tested containing large dollar amounts

Appropriateness of audit evidence:

Quality of the evidence gathered. Quality is measured as a function of relevance and reliability

Relevance of Audit Evidence

Relates to the connection between the audit procedure being performed and the assertion being audited

Relevance: Purpose of an audit procedure

Risk Assessment, Test of Controls, and Substantive Procedures

Relevance: Direction of Testing

Overstatement through vouching (testing existence) Understatement through tracing (testing completeness)

Vouching

Verifies the entries in the company’s book through the examination of documentation or vouchers, such as invoices, notes, statements, or receipts. Selects items from journal entries and examines underlying documentation

Tracing

Looks at a financial document and traces the path of that document back to the financial statements to verify that the document has been properly recorded in the financial statements. Selects source document and follows it to the journals

Characteristics of Reliable Evidence: Independence of provider

Evidence obtained from a source outside the entity is more reliable that that obtained from within.

Characteristics of Reliable Evidence: Effectiveness of client’s internal controls

When a client’s internal controls are effective, evidence obtained is more reliable than when they are weak

Characteristics of Reliable Evidence: Auditor’s direct knowledge

Evidence obtained directly by the auditor through physical examination, observation, recalculation, and inspection is more reliable than information obtained indirectly

Characteristics of Reliable Evidence: Qualification of individuals providing the information

Although the source of information is independent the evidence will not be reliable unless the individual providing it is qualified to do so

Characteristics of Reliable Evidence: Degree of objectivity

Objective evidence is more reliable than evidence that requires considerable judgment to determine whether it is correct

Characteristics of Reliable Evidence: Timeliness:

Can refer either to when audit evidence is accumulated or to the period covered by the audit

Hierarchy of Audit Evidence

1. Auditor’s direct personal knowledge 2. External evidence 3.Internal evidence 4. Oral evidence

Audit Evidence: Physical Examination of Tangible Assets

Inspection or count by the auditor of a tangible assets. (Cash or inventory)

Audit Evidence: Confirmations

Inquiries to external parties about events, account balances, or transactions

Audit Evidence: Inspection of Documentation

Auditor’s examination of the client’s documents and records (invoices and bank statements)

Audit Evidence: Analytical Procedures

Understand the client’s industry and business. Assess the entity’s ability to continue as a going concern. Indicate the presence of possible misstatements in the financial statements \n

Audit Evidence: Client Inquires

Obtaining of written or oral information from the client in response to questions from the auditor

Audit Evidence: Reperformance

Auditor’s independent tests of client accounting procedures or controls that were originally done as part of the entity’s accounting and internal control system

Audit Evidence: Recalculation

Rechecking a sample of calculations made by the client

Audit Evidence: Observation

Tour plant to obtain a general impression of client’s facilities. Observation is rarely sufficient by itself. Often need to corroborate with another kind of evidence

Auditing Management Estimates

Understand the process used in developing management

estimates. Determine if the estimates are reasonable and appropriate

Related Party Transactions

Transactions a client has with other companies or individuals related to either the client or client’s senior management

Auditor’s specialist

Auditors may need to rely on work performed by an

outside specialist/expert. Expertise in a field other than accounting or auditing is necessary to for some accounts

Documenting Audit Evidence

Record that forms the basis for the auditor’s representations and conclusions

Permanent Files

Intended to contain data of a historical or continuing nature pertinent to the current audit

Current Files

• Audit program, General information, Working trial balance, Adjusting and reclassification entries, Supporting schedules

Auditdata analytics (ADA)

The science and art of discovering and analyzing patterns, identifying anomalies, and extracting other useful information in data underlying or related to the subject matter of an audit through analysis, modeling, and visualization for planning and performing the audit

ADA Step 1

Plan the ADA

ADA Step 2

Access and prepare the data for ADA

ADA Step 3

Consider the relevance and reliability of the data used

ADA Step 4

Perform the ADA

ADA Step 5

Evaluate the results and conclude whether the purpose and specific objectives of performing the ADA have been achieved

Step 2: Access and Prepare the ADA

1. Determine that the data is complete. 2. Verify that the data is the same data that is used to prepare the financial statements. 3. Checkthenumericalcontinuityofthedata.Aretheremissing numbers (e.g., missing numbers in the sequence of invoices)? 4. Ensurethedataformatsareconsistentthroughoutthedata used for ADA

Step 3: Consider the Relevance and Reliability

It is particularly important that the data be relevant to the assertion being tested

Main Steps with Accessing and Preparing ADA

Make a copy of the data- never use/modify original data of the client. Verify that the data is complete. Make sure the data is in a consistent format and does not need to be cleaned. auditor uses ADAEvaluate that the data is relevant and reliable

Auditor use of ADA

Looking for anomalies, or balances or transactions that do not meet the auditor’s expectations

Techniques for ADA: Cluster

Transactions or balances based on a particular characteristic or multiple characteristics

Techniques for ADA: Matching

Characteristics of two populations to see if there are any overlaps

Techniques for ADA: Statistical Analysis

Such as regression analysis, notable items are identified using statistics and finding causalities.

Techniques for ADA: Visualization

Auditors plots certain characteristics of a population of account balances or transactions, looking for unusual characteristics

Gather and Evaluate Evidence: Sampling

Testing the effectiveness of controls (attributes)

Direct tests of account balances and assertions (including monetary units)

Gather and Evaluate Evidence: Data Analytics

Tools that the auditor can use for obtaining, analyzing, visualizing, and evaluating client data

Audit Sampling: Appropriate

Examination of documents, reperforming

calculations, or sending confirmations

Audit Sampling: Not Appropriate

Inquiry,observation,andanalytical procedures

Audit sampling: Use

Testing of the operating effectiveness of controls and transactions. Accuracy of accountbalances

Test of Contorl

The operative effectiveness of the internal controlsData analytics tools

Substantive Test of Transactions

The monetary correctness of transactions in the accounting system

Test of details of balances

That the dollar amount of the account balances are materially misstated

Data analytics tools

Include qualitative and quantitative techniques. Processes to enhance productivity and effectiveness of auditors

Situations When the Auditor Is Likely to Use ADA

Evidence to support the audit test is available in electronic form. The audit population is large, and the auditor’s tests are supported by reliable and relevant data in electronic form. Relevant data is reliable and internal controls over the reliability of data are strong. Relevant data is clean or can be cleaned up easily

Situations When the Auditor Is Likely to Use Audit Sampling

Evidence to support the audit test is not available in electronic form (e.g., observing the existence of inventory). The audit population is small and can efficiently be tested using traditional audit procedures. Relevant data is not reliable and internal controls over the reliability of data are weak. Relevant data may be in different formats and is not easy to use

Population

a group of transactions or items for which the auditor wants to estimate the effectiveness of controls or estimate the extent of material misstatement

Sample Size

number of items should that be selected for audit testing

Sample selection

Items that should be included in the sample.

Sample evaluation

the inferences that can be made about the overall population from the sample

Non-sampling risk

the auditor makes the wrong conclusions and fails to identify existing exceptions in the sample. Those erroneous conclusions are independent from sampling

Sampling risk

the auditor may reach an incorrect conclusion because the sample that was not representative of the population. The sampling risk may be reduced by increasing the sample size

Sampling risk: Test of Controls

Risk of assessing control risk too low of internal control reliability. Risk of assessing control risk too high of internal control reliability

Sampling risk: Test of Details of Account Balances

Risk of incorrect acceptance of book value. Risk of incorrect rejection of book value

Sampling Risk: Risk of Over Reliance \n

Risk that the auditor will conclude that internal controls are effective (i.e., control risk is low) when internal controls are actually not effective

Sampling Risk: Risk of Under Reliance

Risk that the auditor will conclude that the internal controls are not effective (i.e., control risk is high) when internal controls are actually effective

Test of Details of Account Balances

Risk of incorrect acceptance of book value. Risk of incorrect rejection of book value

Statistical Sampling

Uses mathematical measurements to calculate formal statistical results and quantify sampling risk

Non-statistical sampling

Selection of sample items based on the auditor’s judgment, which does not permit the numerical measurement of the sampling risk. Typically the sampling method is not statistical if the auditor uses judgement for one of the followings: (i) sample size, (ii) items selected in the sample, and (iii) evaluation of the sample

Attributes sampling

A statistical, probabilistic method of sample evaluation. It is used to estimate the rate of control procedure failures based on selecting a sample and performing the appropriate audit procedure

Attributes sampling: Step 1

Define the attributes of interest and what constitutes failure(s)

Attributes sampling: Step 2

Define the population from which the auditor takes the sample

Attributes sampling: Step 3

Determine the sample size

Attributes sampling: Step 4

Determine the method of selecting the sample

Attributes sampling: Step 5

Select the sample items and perform the test of control

Attributes sampling: Step 6

Evaluate the sample results and consider the effect on planned substantive procedures and the opinion on internal control effectiveness

Attributes sampling: Step 7

Document all phases of the sampling process

Allowable Risk of Over reliance (ARO)

typically set at 5% or 10%. Higher the number higher risk auditor is willing to take

Tolerable rate of deviation

Represents the level of exception below which the auditor will permit an exception in the population and still be willing to conclude that the controls are operating effectively

Testing multiple attributes

When testing several controls of attributes using the same documentation ,the auditor should use the same sampling risks, hence same sample size for all the tests, even though it will result in over testing some of the attributes

Factual/known misstatements

They have been identified and are certain

Projected/likely misstatements

They are extrapolated by factual misstatements and projected on a given population

Tolerable misstatements

They are a monetary threshold set by the auditor that is compared with the actual misstatement. It is the maximum tolerable amount of misstatement for the auditor

Expected misstatements

They represent the misstatements the auditor expects to find based on prior audits

Monetary unit sampling

A statistical sampling method that provides misstatements expressed in dollar amounts