Chapter 5

Audit Evidence and Documentation

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Audit Risk

The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated

This is the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP.

Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.
5-2

Financial Statement Assertions

Assertions

about account balances

(Accounts) Assertions about classes of transactions and events (Transactions) Assertions about presentation and disclosure (Disclosures)

5-3

Financial Statement Assertions: Auditing

Standards Board and International Standards
Accounts Existence Rights and obligations Completeness Valuation and allocation Completeness Accuracy Cutoff Classification Classification and understandability Transactions Occurrence Disclosures Occurrence Rights and obligations Completeness Accuracy and valuation

5-4

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 CutoffTransactions and events have been recorded in the correct accounting period Valuation, Allocation and AccuracyAll 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

5-5

Audit Risk
Audit Risk =
=

Risk of Material Misstatement Inherent Risk

Risk That the Auditors Fail to the Misstatement * Detection Risk

Control 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 companys 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.
5-6

Audit Risk Formula

AR = IR * CR * DR
AR IR CR DR = = = = Audit risk Inherent risk Control risk Detection risk

5-7

Audit Risk
Figure 5. 2

5-8

Inherent Risk

Factors that affect inherent risk: Nature of the client and its environment Nature of the particular financial statement element Business characteristics indicative of high inherent risk:

Inconsistent profitability of client Operating results highly sensitive to economic factors Going concern problems Large known and likely misstatements detected in prior audits Substantial turnover, questionable reputation, or inadequate accounting skills of management

5-9

Assertions with high inherent risk

Involve:

Difficult to audit transactions or balances Complex calculations Difficult accounting issues Significant judgment by management Valuations that vary significantly based on economic factors

5-10

Types of transactions

Routine

Recurring financial statement activities recorded in the accounting records in the normal course of business Lower inherent risk Involve activities that occur only periodically such as the taking of physical inventories High inherent risk Activities that create accounting estimates Higher inherent risk

Nonroutine

Estimation transactions

5-11

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

5-12

Appropriateness of Audit Evidence

To be appropriate audit evidence must be:

PrinciplesAudit evidence is ordinarily more reliable when it is

Relevant Reliable

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

5-13

Reliability of Certain Types of Audit Evidence

RELIABILITY High TYPE Physical Documentary External External/Internal Internal Low Client Representations EXAMPLE Inventory Observation

Cutoff Bank Statement Purchase Invoice Sales Invoice

Management Representation Letter

5-14

Types of Audit Evidence

Type Example

Accounting Information System

Documentary evidence Third-party representations Physical evidence Computations Data interrelationships Client representations

The accounting records and support for transactions and journal entries
Checks, invoices, contracts, minutes of meetings. Confirmations, lawyers letters, specialists reports Examination of asset Footing, recalculations Analytical procedures Representation letter

5-15

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

Further Audit Procedures

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

5-16

Substantive Procedures
Analytical

procedures Tests of details

Tests of account balances Tests of classes of transactions Tests of disclosures

One may change the scope of audit procedures by changing the (NTE, or reordered as NET):
Nature (type and form) Timing (when performed) Extent (quantity of evidence obtained)
5-17

Nature and Timing of Procedures

Holding the extent of procedures constant, one may increase the scope of procedures (make them more effective) by either changing the

Nature-- obtain more reliable evidence

often externally generated evidence.

Timing--wait until year-end to obtain evidence from entire set of transactions as contrasted to performing interim testing, say two months prior to year-end and simply updating those procedures.
5-18

Extent of Procedures
Holding other factors such as the nature and timing of procedures constant:

The greater the risk of material misstatement, the greater the needed extent of substantive procedures The main way to increase the extent of audit procedures is to examine more items Sample sizes should reduce detection risk so as to restrict audit risk to a low level
5-19

Analytical Procedures (1 of 2)

Steps involved

Develop expectation of account (or ratio) balance Determine amount of difference that can be accepted without investigation Compare the companys account (ratio) with the expectation Investigate and evaluate significant differences
Prior period information Anticipated results Relationships among elements of financial information within a period Industry information Relationships between financial information and relevant nonfinancial data.

Developing an expectation

5-20

Analytical Procedures (2 of 2)

Types of Expectations Trend analysisanalyze changes in accounts of a company over time Ratio analysis compare relationships between two or more financial statement accounts or comparisons of account balances to nonfinancial data Liquidity (e.g., current ratio) Leverage (e.g., debt to equity) Profitability (e.g., gross profit percentage) Activity (e.g., inventory turnover)

5-21

Ratio Analysis
Approaches

to ratio analysis

Horizontal analysis
Review ratios 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

Other methods
Regression analysis, reasonableness test
5-22

Identifying Potential Misstatements

5-23

Basic Approaches to Auditing Accounting Estimates

Review

and test managements process for developing the estimate. Independently develop an estimate to compare to managements estimate. Review subsequent events or transactions bearing on the estimate.
5-24

Auditing Fair Values

Inputs to use in applying valuation techniques (FAS 157) Level 1 inputs of observable quoted prices in active markets for identical assets or liabilities
Ex. A closing stock price in WSJ

Level 2 inputs of observable quoted prices, generally for similar assets or liabilities in active markets
Ex. Company discounts future cash flows on its not publicly traded debt securities at rate used by market for publicly traded debt securities

Level 3 inputs that are unobservable for the assets or liability

Ex. A private company uses judgment to determine a proper rate to discount the future cash flows of its not publicly traded securities

5-25

Related Party Transactions

Disclosure

requirements must be met Primary challenge is identifying undisclosed related party transactions

Determine related parties

Inquiries of management Review SEC filings, stockholders listings and conflict-of-interest statements

Be alert for transactions with related parties and any transactions with unusual terms
5-26

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

5-27

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
5-28

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
5-29

Types of Working Files

Current

files

Current year working papers Index and cross-referencing

Permanent

files

Items of continuing audit interest

5-30

5-31

Preparation of a Working Paper Figure 5.8

5-32