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.
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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)

5-3

Financial Statement Assertions: Auditing

Standards Board and International Standards
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

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

Control
Risk

Risk That the

Auditors Fail to
the Misstatement
*

Detection
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

Nonroutine

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

Estimation transactions

Activities that create accounting estimates

Higher inherent risk

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:

Relevant
Reliable

PrinciplesAudit 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

5-13

Reliability of Certain Types of

Audit Evidence
RELIABILITY
High

Low

TYPE
Physical

EXAMPLE
Inventory Observation

Documentary
External
External/Internal
Internal

Cutoff Bank Statement

Purchase Invoice
Sales Invoice

Client Representations

Management Representation
Letter

5-14

Types of Audit Evidence

Type

Example

Accounting Information System

The accounting records and support

for transactions and journal entries

Documentary evidence

Checks, invoices, contracts, minutes

of meetings.

Third-party representations

Confirmations, lawyers letters,

specialists reports

Physical evidence

Examination of asset

Computations

Footing, recalculations

Data interrelationships

Analytical procedures

Client representations

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

Further Audit Procedures

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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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

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 (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