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)

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 Financial Statement Assertions: Auditing
Standards Board and International Standards
Accounts Transactions Disclosures
Existence Occurrence Occurrence
Rights and Rights and
obligations obligations
Completeness Completeness Completeness
Valuation and Accuracy Accuracy and
allocation valuation
Cutoff
Classification Classification and
understandability

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 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

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 Audit Risk

Risk of Material Risk That the

Audit Risk = Misstatement * Auditors Fail to
the Misstatement

= Inherent Control Detection

Risk * Risk * 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.
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 Audit Risk Formula

AR = IR * CR * DR

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

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 Audit Risk

Figure 5. 2

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 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

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 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

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 Types of transactions
Routine

Recurring financial statement activities recorded in the
accounting records in the normal course of business

Lower inherent risk
Nonroutine

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

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 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

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 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

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 Reliability of Certain Types of
Audit Evidence

RELIABILITY TYPE EXAMPLE

High Physical Inventory Observation

Documentary
External Cutoff Bank Statement
External/Internal Purchase Invoice
Internal Sales Invoice

Low Client Representations Management Representation

Letter

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 Types of Audit Evidence
Type
Accounting Information System
Documentary evidence
Third-party representations
Physical evidence
Computations
Data interrelationships
Client representations
Example
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
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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
Analyticalprocedures
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 re-
ordered as NET):
Nature (type and form)
Timing (when performed)
Extent (quantity of evidence obtained)

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 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.

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 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

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 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)

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 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

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Identifying Potential
Misstatements

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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.

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 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

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 Related Party Transactions
Disclosurerequirements 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

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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

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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

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 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
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Types of Working Files

Current files
Current year working papers
Index and cross-referencing
Permanent files
Items of continuing audit
interest

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Preparation of a Working Paper
Figure 5.8

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