These lectures covers sufficient appropriate audit evidence including inquiry, observation, inspection, recalculation, re-performance, confirmation, analytical procedures, vouching and tracing.
Sufficient Appropriate Evidence
Example: Reliability of Evidence
Audit Evidence Procedures
Analytical Procedures During an Audit
Example: Analytical Procedures During an Audit
Financial ratios for Auditing Purposes
Auditing is a systematic process of objectively obtaining and evaluating evidence regard- ing assertions about economic actions and events. ‘The auditor shall design and perform audit procedures that are appropriate in the circumstances for the purpose of obtain- ing sufficient appropriate audit evidence.’1 Evidence is anything that can make a person believe that a fact, proposition or assertion is true or false.
Audit evidence is all of the information used by the auditor in arriving at the conclusions on which the audit opinion is based. Audit evidence includes the accounting records and other information underlying the financial statements. Audit evidence is different from the legal evidence required by forensic accounting. In a civil lawsuit, evidence must be strong enough to incline a person to believe one side or the other. In a criminal case, evidence must establish proof of a crime beyond a reasonable doubt. Audit evidence provides only reasonable assurance.
An auditor obtains audit evidence by one or more of the following evidence-gathering techniques: ■ inquiry; ■ observation; ■ inspection (of tangible assets, records or documents); ■ recalculation; ■ re-performance; ■ confirmation; ■ analytical procedures.
The most frequently used technique for evidence gathering is inquiry. Inquiry consists of seeking information of knowledgeable persons inside or outside the entity. Inquiry of the client is the obtaining of written or oral information from the client in response to specific questions during the audit. Inquiries may range from formal written inquiries, addressed to third parties, to informal oral inquiries, addressed to persons inside the entity. Responses to inquiries may provide the auditor with information not previously possessed or with corroborative audit evidence. Alternatively, responses might provide information that differs significantly from other information that the auditor has obtained, for example, information regarding the possibility of management override of controls. In some cases, responses to inquiries provide a basis for the auditor to modify or perform additional audit procedures.
In a typical audit, the largest amount of audit evidence is obtained from client inquiry, but it cannot be regarded as conclusive because it is not from an independent source and might be biased in the client’s favour. Therefore, the auditor must gather evidence to corroborate inquiry evidence by doing other alternative procedures. For example, the auditor generally makes inquiries about internal control, accounting entries, and procedures. Later, for corroboration, the auditor may observe the control procedures (observation) or review related documentation (inspection).
Observation consists of looking at a process or procedure being performed by others, for example, the observation by the auditor of the counting of inventories by the entity’s per- sonnel or observation of internal control procedures that leave no audit trail. Observation provides audit evidence about the performance of a process or procedure, but is limited to the point in time at which the observation takes place and by the fact that the act of being observed may affect how the process or procedure is performed. Observation is mostly visual, but also involves all the other senses. Hearing, touch and smell may also be used in gathering evidence. For example, it is typical for the auditor to do a site visit at the client’s facilities. On site visits the auditor can get an idea of the imple- mentation of internal controls, notice what equipment is utilised and what equipment may be collecting dust – or rusting. An auditor with a good knowledge of the industry can tell what equipment and methods are obsolete by observing. Sufficient evidence is rarely obtained through observation alone. Observation tech- niques should be followed up by other types of evidence gathering procedures.
Inspection (of Tangible Assets, Records or Documents):
Inspection consists of examining records, documents or tangible assets. Inspection is the auditor’s examination of the client’s documents and records to substantiate the information that is or should be included in the financial statements. Examples of evidence gathering by inspection techniques is the review by an auditor of sales orders, sales invoices, shipping documents, bank statements, customer return documents, customer complaint letters, etc. Other examples are the conduct of a thorough mechanical inspection of cash registers and point-of-sales devices and review of electronic records via Computer Assisted Audit Techniques (CAATs).
Vouching and Tracing:
The use of documentation to support recorded transactions or amounts is called ‘vouch- ing’. The review of how source documents lead to account balances is called ‘tracing’. Vouching is an audit process whereby the auditor selects sample items from an account and goes backwards through the accounting system to find the source documentation that supports the item selected (e.g. a sales invoice). For example, to vouch the existence of recorded acquisition transactions, the audit procedure would be to trace from the acquisitions journal to supporting vendor’s invoices, cancelled cheques or receiving reports. On the other hand, tracing tracks transactions in the opposite direction, form source documents to account total balance. Tracing is an audit procedure whereby the auditor selects sample items from basic source documents and proceeds forward through the accounting system to find the final recording of the transaction (e.g. in the ledger).
Recalculation and Re-performance:
Recalculation consists of checking the arithmetical accuracy of source documents and accounting records or of performing independent calculations. Some common recalcula- tion audit procedures are extending sales invoices and inventory, adding journals and subsidiary records, calculating excise tax expense, and checking the calculation of depre- ciation expense and prepaid expense. Audit procedures to check the mechanical accuracy of recording include reviews to determine if the same information is entered correctly in point-of-sales records, receiving reports, journals, subsidiary ledgers and summarised in the general ledger. Computation evidence is relatively reliable because the auditor performs it. Recalculation may be performed through the use of CAATs (e.g. ACL), for instance to check the accuracy of totals in a file.
Re-performance is the auditor’s independent execution of procedures or controls that were originally performed as part of the entity’s internal control, either manually or through the use of CAATs, for example, re-performing the ageing of accounts receivable.
Reliability and Cost of Audit Procedures The most reliable evidence-gathering techniques (audit procedures) should be used whenever they are cost effective. The quality of internal controls has a significant effect on reliability. Furthermore, a specific substantive audit procedure is rarely sufficient by itself to provide competent evidence to satisfy the audit objective. However, assuming good internal controls and the ability to choose a specific method, a list of the most reliable to the least reliable evidence-gathering techniques are in general: ■ recalculation, ■ inspection, ■ re-performance, ■ observation, ■ confirmation, ■ analytical procedures, ■ inquiry. The most expensive evidence-gathering techniques are confirmation and inspection.
Confirmation is costly because of the time and outlay required in preparation, mailing, receipt and follow-up. Inspection procedures that require the presence of both the client and auditors, such as an inventory count, are also expensive. Confirmation of documents is moderately expensive if clients are organised and have documents easily available.
The three least expensive evidence-gathering procedures are observation, analytical procedures and inquiries. Observation is normally done concurrently with other audit procedures. The evidence-gathering procedures in order of cost from most costly to least costly are in general: ■ confirmation (most costly), ■ inspection, recalculation, ■ re-performance, ■ observation, ■ analytical procedures, ■ inquiry (least costly).
In general, audit evidence from external sources (e.g. external confirmation of cash account received from a bank) is more reliable than evidence generated internally. Evidence obtained directly by the auditor is more reliable than that obtained from the client entity and more reliable than evidence obtained indirectly or by inference (e.g. inquiry about the application of a control). Written documents are the second most reli- able audit evidence. External confirmation combines direct participation by the auditor and written documentation from an external source. ■ Confirmation Confirmation consists of the response to an inquiry of a third party to corroborate infor- mation contained in the accounting records. For example, the auditor ordinarily seeks direct confirmation of receivables by communication with debtors. Confirmation is the act of obtaining audit evidence from a third party in support of a fact or condition. Illustration 10.2 gives a summary of the characteristics of confirmation as an evidence- gathering technique.
Confirmation procedures are typically used to confirm the existence of accounts receivable, investments and accounts payable, but they may be used to confirm existence, quantity and condition of inventory held by third parties (e.g. public warehouse consignee) on behalf of the entity. They may be used to verify bank balances with banks; cash surrender value of life insurance or insurance coverage with insurers; notes payable with lenders or bondholders; shares outstanding with stock transfer agents; liabilities with creditors; and contracts terms with customers, suppliers and creditors. Because confirmations from independent third parties are usually in writing, and are requested directly by the auditor, they are highly persuasive evidence. The main disadvantage of confirmations is that they are costly, time-consuming and an inconvenience to those asked to supply them. Confirmation of Management Assertions Audit evidence is collected to verify management assertions.
External confirmation of an account receivable provides strong evidence regarding the existence of the account as at a certain date. Confirmation also provides evidence regarding the operation of cut-off procedures. Similarly, in the case of goods held on consignment, external confirmation is likely to provide strong evidence to support the existence and the rights and obligations assertions. When auditing the completeness assertion for accounts payable, the auditor needs to obtain evidence that there is no material unrecorded liability. Therefore, sending confirmation requests to an entity’s principal suppliers asking them to provide copies of their statements of account directly to the auditor, even if the records show no amount currently owing to them, will usually be effective in detecting unrecorded liabilities.