Audit Evidence and

Documentation

Chapter 5

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Financial Statement Assertions

Assertions about account balances (Accounts)

Assertions about classes of transactions and events (Transactions)

Assertions about presentation and disclosure (Disclosures)

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Financial Statement Assertions

Accounts Transactions Disclosures

Existence Occurrence Occurrence

Rights and obligations

Rights and obligations

Completeness Completeness Completeness

Valuation and allocation

Accuracy Accuracy and valuation

Cutoff

Classification Classification and understandability

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Combined Assertions Used in this Text

Existence or Occurrence--Assets, liabilities, and equity interests exist and recorded transactions have occurred

Rights and Obligations--The company holds rights to the assets, and liability are the obligations of the company

Completeness--All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded

Cutoff—Transactions and events have been recorded in the correct accounting period

Valuation, Allocation and Accuracy—All transactions, assets, liabilities and equity interests are included in the financial statements at proper amounts

Presentation and Disclosure--Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressed

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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.

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Audit Risk Formula

AR = IR * CR * DR

AR = Audit riskIR = Inherent riskCR = Control riskDR = Detection risk

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Audit Risk

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The Third Field Work Standard

Third standard of field work: The auditor must obtain sufficient

appropriate audit evidence by performing audit procedures to perform a reasonable basis for an opinion regarding the financial statements under audit

Sufficient audit evidence The quantity of audit evidence that must be

obtained

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Appropriateness of Audit Evidence

To be appropriate audit evidence must be: Relevant Reliable

Principles—Audit evidence is ordinarily more reliable when it is Obtained from knowledgeable independent

sources outside the company rather than nonindependent sources

Generated internally through a system of effective controls rather than ineffective controls.

Obtained directly by the auditor rather than indirectly or by inference

Documentary in form rather than oral Provided by original documents rather than copies

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Reliability of Certain Types of Audit Evidence

RELIABILITY TYPE EXAMPLEHigh Physical Inventory Observation

DocumentaryExternal Cutoff Bank StatementExternal/Internal Purchase InvoiceInternal Sales Invoice

Low Client Representations Management Representation Letter

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Types of Audit Evidence

Accounting information system Documentary evidence Third-party representations Physical evidence Computations Data interrelationships Client representations

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Overall Types of Audit Procedures

Risk assessment procedures—To obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatement

Tests of controls—When appropriate, to test the operating effectiveness of controls in preventing material misstatements

Substantive procedures—To detect material misstatements at relevant assertion level. Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosures

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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

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Analytical Procedures--I Steps involved

Develop expectation of account (or ratio) balance Determine amount of difference that can be accepted

without investigation Compare the company’s account (ratio with the

expectation Investigate and evaluate significant differences

Developing an expectation Prior period information Anticipated results Relationships among elements of financial information

within a period Industry information Relationships between financial information and

relevant nonfinancial data.

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Analytical Procedures--II

Categories of ratios Liquidity (e.g., current ratio) Leverage (e.g., debt to equity) Profitability (e.g., gross profit percentage) Activity (e.g., inventory turnover)

Basic approaches Horizontal analysis—analyze ratios of a company over

time Cross sectional analysis—analyze ratios of similar

firms at a point in time Vertical analysis—analyze relationships within a period

“Common size” statements prepared

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Identifying Potential Misstatements

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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.

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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

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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

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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

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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

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Types of Working Files

Current files Permanent files

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Preparation of a Working Paper – Figure 5.8