The University of Sydney Business School

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ACCT3014 - Auditing and Assurance
Semester 1, 2013

Week 5 Lecture Audit Evidence

Materiality Audit Evidence Audit Assertions (again!) Audit Procedures

Business School Auditing and Assurance

Multiple Choice
1. Which of these steps in planning the audit is out of sequence? a) obtaining an understanding of the entitys internal control structure. b) obtaining an understanding of the entity and its environment. c) making preliminary judgements about materiality levels. d) considering the audit risk 2. Which of the following is not generally considered one of the factors that make up the control environment? a) audit committee. b) organisational structure. c) accounting package used. d) board of directors. 3. Which of the following is an example of how an auditor might document the understanding of internal control? a) internal control questionnaire. b) flow chart and narrative memoranda. c) both of the above. d) none of the above.
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Recap Last Weeks Lecture

ASA315 mandates that Auditor obtains an Understanding of the Clients Internal Controls
Context to identify and assess risk of material misstatement Auditor identifies and tests controls that mitigate certain risks: Risk of fraud Complexity of transactions Related parties ...... Lets revisit Erics Woolworths Example
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Lecture Discussion Question

You are about to Audit Woolworths: Woolworths has more than 3,000 stores across Australia, that span food, liquor, petrol, general merchandise, home improvement and hotels. Woolworths is a proud, home-grown Australian business, employer of more than 195,000 people and committed business partner of many thousand local farmers, producers and manufacturers.

In your BR Approach for the following identified risks in Woolworths , Determine a PRACTICAL Internal Control procedure that would mitigate the risk:
Overpayment of overtime to casual employees

Inventory being stolen especially from loading docks and shelves

Payments being made twice to the same supplier (especially diary products) A number of Terminated Full Time Employees are still being paid for a fortnight after they have left Woolworths

Lecture Outline
Materiality-What does it mean and How to apply it? Importance of Adequate Audit Evidence Audit Procedures and Various Business Cycles

Audit Assertions-Why are they crucial to the Audit?

1. Pre-engagement activities ASA 210

1.1 1.2 1.3 2.1 2.2 2.3 2.4

Accept / reject new client Established terms of engagement Engagement letter Obtain knowledge of the business ASA 315 (including ASA 250) 2.1.1 Preliminary analytical procedures Appraisal of risks, including fraud risk (ASA 240) going concern (ASA 570) ASA 315 Estimate of materiality

2. Planning activities ASA 300/315

Review of control components

2.4.1 Preliminary evaluation of control environment Develop overall audit plan (i.e. develop an audit strategy) in response to risks ASA 330 2.5.1 Determine reliance on internal controls 2.5.2 Determine extent and nature of testing 2.5.3 Write audit plan Assignment of staff Tests of control 3.1.1 Conducts tests 3.1.2 Make final evaluation of internal control 3.1.3 Modify audit approach Substantive testing activities 3.2.1 Conduct substantive tests of transactions and balances 3.2.2 Conduct substantive analytical procedures 3.2.3 Evaluate results of substantive procedures 3.2.4 Modify audit approach Obtain representations 3.3.1 Management 3.3.2 Solicitors 3.3.3 Bank Review financial report Review audit results Subsequent events Fraud and error ASA 240 4.5 Related party transactions 4.6 Formulate audit opinion 4.7 Draft issue reports (ASA 700/705)

2.5

2.6 3.1

A U D I T P R O C E S S

3.2

3. Audit evidence ASA 500

3.3

4. Opinion formulation and reporting activities

4.1 4.2 4.3 4.4 5.1 5.2 5.3 5.4

5. Continuous activities
5.5 5.6 5.7

Supervise conduct of examinations Review work of assistants Consider appropriateness of continuing relationship with client Make required special communication 5.4.1 Material weaknesses of internal accounting control 5.4.2 Material errors or irregularities Consult with appropriate persons in connection with special problems Document work performed, findings, and conclusions in appropriate working papers Consider going concern (ASA 570)

Materiality In the context of an Audit

Materiality
Preliminary estimate of Materiality when planning ASA320 Materiality means information individually or in aggregate, that if omitted from financials may affect economic decisions of users Determine and Plan Materiality for Financial Report as a whole Rule of thumb depends on judgements about: Relevance Stability Predictability
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Materiality Rules of Thumb

Common Bases Range of % Applied to Base

Net Profit

5-10

Total Revenue

0.5-1 0.5-1

Total Assets

Equity

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Materiality Example
In carrying out year end Inventory work, you determine that certain inventory is $200k below cost price. Management refuses to write down value of Inventory. Determine whether the $200k is material? Additional information included:
Total Assets Current Assets Inventories Net Assets Profit $24,000,000 $12,000,000 $10,000,000 $18,000,000 $3,400,000

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Audit Evidence
Auditors are required by Auditing Standards to accumulate sufficient appropriate evidence on which to base their opinions on the financial statements

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ASA 500: Audit Evidence

The auditor shall design and perform audit procedures that are appropriate in the circumstances for the purposes of obtaining sufficient appropriate audit evidence (para. 6).
__________________

Audit evidence is obtained from performance of: - Tests of controls

(Internal Controls)
- Substantive testing

(Financial Information i.e. $)

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Sufficient and Appropriate Audit Evidence (ASA 500.5)

Appropriate = measure of quality (i.e. relevance and reliability) Sufficient = measure of quantity

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Appropriateness of Audit Evidence

Relevance means that evidence must be sufficient with respect to each of the auditors objectives The reliability of evidence is influenced by factors such as the source and nature of the information, and its timeliness and objectivity The auditor is not expected or required to have an absolute, certain or guaranteed basis for an opinion

In arriving at a professional judgment of reasonable assurance, the auditor is guided by the persuasiveness of the evidence Given that professional judgment is involved, different auditors will not always reach identical conclusions about the quantity and quality of evidence needed to reach an opinion on financial statements
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Sufficiency of Audit Evidence

Relates to the quantity of audit evidence Factors that may affect the auditors judgment of sufficiency include: - materiality and risk - economic factors - the size and characteristics of the population
In general, more evidence is needed for accounts that are material to the financial statements

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Audit Evidence (ASA 500)

Audit evidence is a fundamental concept in auditing by which the auditor achieves the objective of reasonable assurance that none of managements assertions is materially misstated, and consists of: - underlying accounting data - all corroborating information available to the auditor Underlying accounting data includes: - books of original entry - general and subsidiary ledgers - related accounting manuals - informal and memorandum records, such as worksheets, calculations and reconciliations

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Sources of Audit Evidence (ASA 500.A1 and A7-A9)

Corroborating information - Documents such as cheques, authorisations for direct bank transfers, invoices, contracts etc. - Confirmations and other written representations - Information from inquiry, observations, inspection and physical examination
Confirmations

Review the invoices

Lawyers Letters

Audit evidence refers to information obtained by the auditor in arriving at the conclusion on which his audit opinion is based on.

Reports of Specialists

Circularise the debtors to confirm directly to the Auditors on their outstanding balances
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Sources of Audit Evidence (ASA 500.A1 and A7-A9)

Evidence can be: Created by outside parties and transmitted directly to auditor Created by outside parties and held by client Created and held by client Electronic documents Computations are: performed independently by auditor used to verify mathematical accuracy of clients analyses and records

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Persuasiveness of Evidence
ASA 500 requires the auditor to obtain sufficient appropriate evidence to support the opinion issued Persuasiveness of evidence is the degree to which the auditor is convinced that the evidence supports the audit opinion Two determinants of the persuasiveness of evidence: Competence Sufficiency

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Audit Procedures
Methods & techniques used by auditor to gather evidence include: Inspection/Physical examination Confirmation Auditing procedures are methods and Documentation techniques used by the auditor to Observation gather and evaluate audit evidence Enquiry Recalculation Re-performance Analytical procedures Many of these procedures can be performed with audit software
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Inspection/Physical Examination
Inspection or count by the auditor of a tangible asset:
o Usually associated with inventory and cash

An objective means of:

o o Ascertaining the quantity and description of the asset Verifying the assets condition or quality

Not sufficient evidence to verify:

o o Ownership; or Valuation

Confirmation
The receipt of a written or oral response from an independent third party verifying the accuracy of information requested by the auditor. Costly to obtain as auditors typically obtain written responses. Two common types of confirmations: Positive: Recipient is asked to return the confirmation in all circumstances Negative: Recipient is requested to respond only when the information is incorrect

Information Confirmed

Documentation
Auditors examination of the clients documents and records to substantiate:
The information that is or should be included in the financial statements

Internal document:
Prepared and used within the clients organisation; and

Retained without ever going to an outside party

e.g. duplicate sales invoice

Documentation (contd)
External document:
May originate outside the client and end up in the clients hands, e.g. vendors invoice May go to an outsider and finally be returned to the client, e.g. cancelled cheques

Vouching
When auditors use documentation to support recorded transactions or amounts

Observation
Use of the senses to assess certain activities Auditor may tour the plant to:
-

Obtain a general impression of the clients facilities

Observe whether equipment is obsolete Watch individuals performing accounting tasks

Observation is rarely sufficient by itself

Inquiries of the Client

Obtaining of written or oral information from the client in response to questions from the auditor Usually cannot be regarded as conclusive given:
it is not from an independent source; and it may be biased in the clients favour

Normally necessary to obtain further corroborating evidence through other procedures

Recalculation
Recalculation involves rechecking a sample of calculations made by the client by: testing the clients arithmetical accuracy including;
extending sales invoices and inventory adding journals and subsidiary records checking the calculation of depreciation expense

checking prepaid expenses

Most auditor recalculations is are performed by computer-assisted audit software as you will see in the Week 9 and 10 Lectures

Reperformance
Reperformance is the auditors independent tests of client accounting procedures or controls that were originally done as part of the entitys accounting and internal control system Whereas recalculation involves rechecking a calculation, reperformance involves checking other procedures

Analytical Procedures
Use of comparisons and relationships:
To assess whether account balances or other data appear plausible May be the only evidence needed for certain audit objectives or small account balances

Are required during the planning and completion phases on all audits

Audit Working Papers will include... Audit Administrative Working Papers

Working Trial Balance

Lead Schedules (Grouping Sheets) Adjusting and Reclassification Journal Entries

Supporting Schedules
Account Analysis Reconciliations

Computational Working Papers

Corroborating Documents
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Tests of Control
Provide evidence about the effectiveness of the design and operations of internal control structure and procedures The auditor should test the design effectiveness of controls by determining whether the company's controls, if they are operated as prescribed by persons possessing the necessary authority and competence to perform the control effectively, satisfy the company's control objectives and can effectively prevent or detect errors or fraud that could result in material misstatements in the financial statements. Procedures the auditor performs to test design effectiveness include a mix of inquiry of appropriate personnel, observation of the company's operations, and inspection of relevant documentation. Walkthroughs that include these procedures ordinarily are sufficient to evaluate design effectiveness.

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Remember
It is not necessary to perform tests of control if we determine that IC would not prevent/detect a material error (i.e. there are no mitigating controls). To perform tests of control to ensure reliability of ICs we need to test them (i.e. perform tests of control) throughout the year (i.e. to ensure continuous existence and effectiveness of internal control.)

The auditor should test the operating effectiveness of a control by determining whether the control is operating as designed and whether the person performing the control possesses the necessary authority and competence to perform the control effectively.
Report of Independent Auditors on Internal Control over Financial Reporting must be completed by Auditors in the USA since SOX
Management letter contains information on weakness in the companys control systems, identified by the auditor, e.g. of errors that could occur because of each weakness and recommendations on how to mitigate those weaknesses

Test of Control Example

In the Woolworths Example we identified PRACTICAL Internal Control procedure that would mitigate the risk: Overpayment of overtime to casual employees Inventory being stolen especially from loading docks and shelves Payments being made twice to the same supplier (especially diary
products)

A number of Terminated Full Time Employees are still being paid for a fortnight after they have left Woolworths

NOW Determine an appropriate TEST OF Control for the above risks

Substantive Procedures
Provide direct evidence as to the fairness of managements financial statement assertions
This category of auditing procedure consists of: - analytical procedures - tests of details of transactions - tests of details of balances

Analytical procedures involve the use of comparisons to assess fairness, e.g. a comparison of an account balance with the previous years balance or a budgeted amount

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Analytical Procedures
Evaluations of financial relationships Analysis of plausible relationships Among financial and non-financial data Understanding the clients industry and business Assessment of the entitys ability to continue as a going concern

Identification of possible misstatements

Reduction of detailed audit tests

Analytical Procedures
Analytical Procedure
Compare gross margin percentage with that of previous years

Possible Error
Overstatement or understatement of inventory and cost of goods sold

Compare inventory turnover with that of previous years

Obsolete inventory. Overstatement or understatement of inventory

Compare unit costs of inventory with those of previous years

Overstatement or understatement of unit costs

Lecture Discussion Question

6.33 HARD Ace Finance Ltd provides retail credit finance for consumers purchasing products from major retail stores, and has been operating for three years. As part of your audit planning for the 2012 audit you intend to perform an analytical review of its operations, and have obtained the following information: 31/3/12 Account Gross finance receivablescurrent Gross finance receivablesnon-current Unearned income Allowance for bad debts Interest income Bad debts expense $000 110 000 280 000 30 000 1 100 50 000 100 30/6/11 $000 88 000 160 000 24 800 1 000 25 000 100 30/06/10 $000 55 000 110 000 16 500 1 000 16 000 100

Required
(a) Identify unusual trends and relationships, and indicate the risk involved.
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Substantive Procedures
Tests of details of transactions involve examining support for the individual debits and credits posted to an account - Examples include vouching the debits in accounts receivable to entries in the sales journal and supporting sales invoices Tests of details of balances involve examining support for the closing balance directly - Examples include confirming accounts receivable directly with the customer

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Substantive Procedures
In testing transactions, the auditor is concerned with tests of:
Omitted transactions and account understatement (tracing source documents to the books of entry)
Invalid or unsupported transactions and account overstatement (tracing recorded transactions to source documents) Needs to be analysed in terms of the BR assessment

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Purpose of Assertions in Auditing Procedures

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Audit Assertions for Financial Information (as per ASA 315.A111)

About classes of transactions and events for the period under audit:
Occurrence Transactions and events that have been recorded have occurred and pertain to the entity. Completeness All transactions and events that should have been recorded have been recorded. Accuracy Amounts and other data relating to recorded transactions and events have been recorded appropriately. Cutoff Transactions and events have been recorded in the correct accounting period. Classification Transactions and events have been recorded in the proper accounts.
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Audit Assertions (cont.)

About account balances as at the period end:
Existence Assets, liabilities and equity interests exist. Rights and Obligations The entity holds or controls the rights to assets, and liabilities are the obligations of the entity.

Completeness All assets, liabilities and equity interests that should have been recorded have been recorded.
Valuation and Allocation Assets, liabilities and equity interests are included in the financial report at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.

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Audit Assertions (cont.)

About presentation and disclosure: (not examinable)
Occurrence and Rights and Obligations Disclosed events, transactions and other matters have occurred and pertain to the entity. Completeness All disclosures that should have been included in the financial report have been included. Classification and Understandability Financial information is appropriately presented and described and disclosures are clearly expressed. Accuracy and Valuation Financial and other information are disclosed fairly and at appropriate amounts.

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Financial Statement Cycles

To design appropriate Substantive Procedures Auditors need to think about and understand the way transactions are recorded in journals and summarised in the general ledger and financial statements sales and collection cycle acquisition and payment cycle payroll and personnel cycle inventory and warehousing cycle capital acquisition and repayment cycle

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Financial Statement contd

Cycle Journals Balance Sheet Income Statement

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Financial Statement contd

Cycle Journals Balance Sheet Income Statement

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Auditing Sales Revenue Procedures

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Auditing Receivables
Audit Objectives Accounts receivable in the aged trial balance agree with related master file amounts, and the total is correctly added and agrees with the general ledger Recorded accounts receivable exist Existing accounts receivable are included Accounts receivable are accurate and correctly classified

Accounts receivable is stated at realisable value

The client has rights to accounts receivable

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Auditing Inventory Procedures

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Audit Procedure Terms

Audit Procedure Terms (contd)

What's on Next Week

Mid Semester Review

Mid Semester Practice Exam held and discussed in class

proof the auditor uses to substantiate a recorded item so that proper reliance may be placed on financial statement figures. Proof of accounting data includes examining source documents in support of a transaction. The degree to which evidence gathering is necessary partly depends on the quality of the client's internal control system. Also, the trend in an account should be looked at over time as a basis for determining the extent of testing required. For example, if travel expense went from 2% of sales last year to 25% of sales this year, this inconsistency requires close examination. Test checks of accounts and transactions are necessary. Evidence can be obtained through various means such as physical verification of inventory records or confirmation letters sent to verify recorded amounts of accounts receivable. Source: http://www.allbusiness.com/glossaries/auditing-evidence/49426221.html#ixzz1nrdn5raA

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