Chapter 5 Audit Documentation and Audit Testing

1. Objectives

1.1 Explain the importance of documentation and describe the nature of documentation required for different types of assignment.

1.2 Define the types of audit tests.

2. Audit Documentation

2.1 DefinitionAudit documentation means the record of audit procedures performed, relevant audit evidence obtained, and conclusions the auditor reached (terms such as “working papers” (工作底稿 ) or “workpapers” are also sometimes used). (HKSA 230 Para 6)

2.2 Audit documentation may be recorded on paper or on electronic or other media. It includes, for example,(a) audit programs,(b) analyses,(c) issues memoranda,(d) summaries of significant matters,(e) letters of confirmation and representation,(f) checklists, and(g) correspondence (including e-mail) concerning significant matters, etc.

(A) Objectives of preparing audit documentation

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2.3 Under HKSA 230, the auditor should prepare, on a timely basis, audit documentation that provides:(a) A sufficient and appropriate record of the basis for the auditor’s

report; and(b) Evidence that the audit was performed in accordance with HKSAs

and applicable legal and regulatory requirements.2.4 In addition to these objectives, audit documentation serves a number of

purposes, including:(a) Assisting the audit team to plan and perform the audit;(b) Assisting members of the audit team responsible for supervision to

direct and supervise the audit work, and to discharge their review responsibilities in accordance with HKSA 220, “Quality Control for Audits of Historical Financial Information;”

(c) Enabling the audit team to be accountable for its work;(d) Retaining a record of matters of continuing significance to future

audits;(e) Enabling an experienced auditor to conduct quality control reviews and

inspections in accordance with HKSQC 1, “Quality Control for Firms that Perform Audits and Reviews of Historical Financial Information, and Other Assurance and Related Services Engagements”, and

(f) Enabling an experienced auditor to conduct external inspections in accordance with applicable legal, regulatory or other requirements.

(B) Contents of working papers

2.5 Working papers should include contents of audit objective, audit testing, evaluation of results and conclusion.(a) Audit objectives – that is the purpose of the audit testing recorded on

that working paper.(b) Sampling method –

(i) Definition of population, sampling units, error or deviation.(ii) Means of determining the sample size.(iii) The sampling method selected.

(c) Audit tests carried out –(i) Details of the items selected.(ii) Details of test and checking on documents, records, etc.

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(iii) Errors or deviations noted and the explanations as to their causes.

(d) Interpretation of the results –(i) Projection of error or deviations.(ii) Auditor’s assessment of the assurance obtained as to the

possible size of actual error or deviation rate.(e) Conclusions –

(i) Nature and details of the conclusion drawn from the sample testing results.

(ii) Details of further action taken where required.2.6 Working papers should show:

(a) The name of the client(b) The balance sheet date(c) The file reference of the working paper(d) The name of the person preparing the working paper(e) The date the working paper was prepared.(f) The subject of the working paper(g) The name of the person reviewing the working paper(h) The date of the review

2.7 Sample working paper

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(C) The use of standardized working papers

2.8 Benefits of using standardized working papers:(a) Efficient in organizing.(b) Facilitate communication and planning.(c) Ease of delegation.(d) Promote control and review.

2.9 Limitations of using standardized working papers:(a) Working papers are designed and organized to meet the circumstances

and the auditor’s needs for each individual audit.(b) It is inappropriate to use a mechanical approach without regard to the

need to exercise professional judgement.

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(D) Audit files

2.10 DefinitionThere are two types of audit files:(a) Permanent file (永久保存檔案 ) – it is kept to record all data of a

permanent nature which provides the necessary background information to the auditor from year to year.

(b) Current file (本期檔案) – it is kept to record all audit work programs and working papers for the year under review.

2.11 Permanent files contain information of continuing importance to the audit.(a) Engagement letters(b) New client questionnaire(c) The memorandum and articles(d) Other legal documents such as prospectuses, leases, sales agreement(e) Details of the history of the client’s business(f) Board minutes of continuing relevance(g) Previous years’ signed accounts, analytical review and management

letters(h) Accounting systems notes, previous years’ control questionnaires

2.12 Current files contain information of relevance to the current year’s audit.(a) Financial statements(b) Accounts checklists(c) Management accounts details(d) Reconciliation's of management and financial accounts(e) A summary of unadjusted errors(f) Ascertaining (探知) and evaluation of internal controls(g) Report to partner including details of significant events and errors(h) Review notes(i) Time budgets and summaries(j) Letter of representation(k) Management letter(l) Notes of board minutes(m) Communications with third parties such as experts or other auditors

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2.13 Test your understanding 1The auditors have two types of working paper files, the current file (CF) and the permanent file (PF). Using the initials and the spaces provided, indicate which file each of the following documents would most likely be filed.

1. A lease agreement.2. A confirmation of financial institution deposits.3. Articles of incorporation.4. An analysis of long-term debt.5. A pension agreement.6. An adjusted trial balance.7. Adjusting journal entries.8. An analysis of miscellaneous expense.9. An analysis of owners’ equity accounts.10. A chart of accounts.

(E) Audit program

2.14 An audit program is a set of instructions to assistants involved in the audit and as a means to control and record the proper execution of the work.

2.15 Advantages of using standardized audit programs:(a) Provide a clear set of instructions on the work to be carried out.(b) Provide a clear record of the work carried out and by whom.(c) Avoid duplication of work.(d) Ensure completeness and avoid missing out the important areas.(e) Ensure continuity from one period to another.(f) Serve as evidence of work done.(g) Serve as a protection against negligence.(h) Prepare for the review of seniors and partners.

2.16 Disadvantages of using a standardized audit program:(a) Encourages mechanistic attitudes which may affect the quality of audit

work.(b) Work done in segments may not tie up with the whole system.(c) May affect initiative and does not encourage spontaneous (自發的 )

responses.

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(d) Audit staff may not probe (查明 ) to the bottom of the matter even though suspicion arises.

(e) Client may be familiar with the audit tests and fraud may be undetected.

(f) Rigid (死板的) and takes no account of the particular circumstances.

(F) Confidentiality, safe custody and ownership

2.17 Judgement may have to be used in deciding the length of holding working papers, and further consideration should be given to the matter before their destruction. As HKSQC 1 indicates, the retention period for audit engagements ordinarily is no shorter than five years from the date of the auditor’s report, or, if later, the date of the group auditor’s report.

2.18 Working papers are the property of the auditors. They are not a substitute for, or part of, the entity’s accounting records.

2.19 Auditors should not release parts of or whole working papers to third parties without permission of the entity. Auditors can disclose the working papers to the entity as long as it does not undermine (破壞) the independence or validity of the audit process.

2.20 Test your understanding 2Audit working papers are the property of the audit client and they are a substitute for the entity’s accounting records. (4 marks)

(HKIAAT Paper 8 Auditing December 2003 Q.B2(V))

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3. Audit Testing

(A) Nature, timing and extent of audit testing

3.1 Nature refers to how the audit procedures are performed.3.2 Timing refers to when audit procedures are performed or the period or date

to which the audit evidence applies.3.3 Extent (or quantity) is the amount of work done when the procedures are

performed.3.4 The nature, timing and extent of audit testing that will be performed by the

auditor and the appropriate evidence mix to be acquired from the audit procedures for each assignment depend on the following factors:(a) Size of the client(b) Relative emphasis among different procedures

E.g. when the tests of controls provide evidence that the internal control system is effective, the extent of relevant substantive procedures may be reduced, but not entirely eliminated.

(c) Effects of information technology(d) Timing of different phases of the audit process(e) Reliance on the work of others

(B) Types of audit procedures

3.5 Audit tests are broadly classified into the following types, details of which are included in Table 1:(a) Risk assessment procedures to identify and evaluate risks of

misstatements of financial statements.(b) Walk-through test which is performed for understanding of the client’s

accounting and control systems.(c) Test of control (or compliance test) (控制測試) which is performed for

determining the control risk.(d) Substantive test (實質性測試 ) which is for verifying the financial

statements and account balances.

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Table 1Audit Procedures

Test Type Nature Purposes Techniques Results Evaluation

a. Risk

assessment

procedures

This refers to the

audit procedures of

obtaining an

understanding of

client’s entity and its

environment on a

continuous and

dynamic process of

collecting and

analyzing

information

throughout the audit.

To support assessments of the risks of material misstatement.

Risk assessment procedures should be starting from inquiries of management regarding the financial reporting procedures and perform analytical procedures to identify possible misstatements and unusual transactions.

The auditor should identify and assess the risks of material misstatement at the financial statement level, and at the assertion level for classes of transactions, account balances, and disclosures.

b. Walk through

test

The auditor takes a

few transactions of

each type and work

through them.

To ensure a correct description and understanding of the system.

The test should be started from the initial of the transaction to the end of it.

Where there are

discrepancies between

the expected system

and the test result, the

auditor should

consider whether:

(i) it is an isolated

case; or

(ii) the expected

system is actually

not in operation.

c. Test of

control

Tests of controls are

concerned with how

internal control

policies or

procedures are

applied, the

consistency of

application during

the period audited,

and by whom they

are applied

To obtain audit evidence about the effectiveness of the:(i) design of the

accounting and internal control systems to prevent and detect the material misstatements; and

(ii) operation of internal controls throughout the period.

(i) Make inquiries of appropriate client personnel.

(ii) Examine documents, records, and reports for evidence of control procedures.

(iii) Observe control related activities.

(iv) Re-perform client control procedures.

If the test of control

reveals that no

exceptions have

occurred, then the

auditor is entitled to

rely on the working of

that control.

If there are

exceptions, the auditor

should determine

whether they are

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isolated cases.

If the existence of

weaknesses in the

system is confirmed,

the auditor should

consider to identify

and test any

alternative controls.

d. Substantive

test

Those tests of

transactions and

balances and review

procedures are

intended to detect

material

misstatements or to

identify accounts

likely to contain

material

misstatements.

To seek to provide audit evidence as to completeness, accuracy and validity of the information contained in the books of accounts or in financial statements.

(i) Tracing – trace from the source documents to the ledger and financial statements to ensure the completeness, validity and accuracy of the balance.

(ii) Vouching – details of the accounting entries and ledger balances can be vouched to the supporting documents to ensure that every transaction recorded has valid evidence to support it.

(i) If the substantive

test reveals that

there is no

exception found,

then the auditor

can conclude that

the balance on the

financial

statements is

fairly stated.

(ii) If not, there may

be material

misstatement on

the financial

statements.

3.6 Test your understanding 3Required:a. Describe the nature and purposes of substantive procedures. (3 marks)b. How would auditors evaluate the results of substantive procedures?

(4 marks)(Adapted HKAAT Paper 8 Auditing June 1999)

3.7 There are three types of substantive procedures:(a) Substantive test of transactions (交易業務實質性測試):

(i) For example, search for the omission of recording purchases and creditors.

(ii) The auditor focuses on finding monetary errors in the transactions, rather than deviations from controls.

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(iii) Substantive tests of transactions are very effective and can gather competent evidence; however, such tests are more time consuming and thus they are costly than analytical procedures, but are less costly than tests of details of balances.

(b) Test of details of balances:(i) Focus on obtaining evidence directly about an account balance

rather than the individual debits and credits comprising the balance.

(ii) Involve the use of external documents, direct confirmations and documents generated by client for verifying the balances on the financial statements.

(iii) But very time consuming and costly to perform.(c) Analytical procedures (分析性程序)

It uses methods such as comparison and relationship to assess whether the transaction and account balance appear reasonable.

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3.8 Test your understanding 4

Required:

Answer the following questions on walk-through test and substantive test in a tabular form.

Walk-through test Substantive test(a) Based on the flow diagram of

the audit process, state the (1 mark) (2 marks)

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reference number of the audit steps at which an auditor would carry out the test.

(b) Briefly explain how an auditor performs the test

(2 marks) (2 marks)

(c) State the purpose of the test (2 marks) (2 marks)(d) How would an auditor

evaluate the test result? (Your answer should cover both positive and negative results.)

(5 marks) (4 marks)

(HKAAT Paper 8 Auditing June 2002)

3.9 Test your understanding 5“Auditors should apply analytical procedures at the planning and overall review stages of the audit.”

In addition to analytical procedures, auditors can obtain audit evidence using other types of audit procedures.

Required:a. What is the meaning of “analytical procedures”? (2 marks)b. What are the purposes of using analytical procedures? (3 marks)c. How can analytical procedures assist the auditors in each of the

following items?(i) Understanding the client’s industry and business;(ii) Assessment of entity’s ability to continue a going concern; and(iii) Indication of the presence of possible misstatements in the

financial statements. (6 marks)d. State FIVE factors that auditors would consider when planning to

perform analytical procedures as substantive procedures. (5 marks)e. State the shortcoming of the analytical procedure of comparing the

account balance of the current year with the account balance of the previous year. Name another analytical procedure that can overcome this shortcoming. (2 marks)

f. Give TWO types of audit procedures, other than analytical procedures, that can enable auditors to obtain audit evidence. (2 marks)

(Total 20 marks)

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(HKAAT Paper 8 Auditing June 2000)

3.10 Test your understanding 6Zak Co sells garden sheds and furniture from 15 retail outlets. Sales are made to individuals, with income being in the form of cash and debit cards. All items purchased are delivered to the customer using Zak’s own delivery vans; most sheds are too big for individuals to transport in their own motor vehicles. The directors of Zak indicate that the company has had a difficult year, but are pleased to present some acceptable results to the members.

The income statements for the last two financial years are shown below:

Required:As part of your risk assessment procedures for Zak Co, identify and provide a possible explanation for unusual changes in the income statement. (9 marks)

(ACCA F8 Audit and Assurance June 2008 Q3(b))

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