CHAPTER 5
Audit Evidence and Documentation
Highlights of the Chapter
1. An audit may be regarded as the process of gathering and evaluating sufficient evidence to provide an adequate basis for expressing an opinion on financial statements. The third standard of field work states:
The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion on regarding the financial statements under audit.
2. Management is responsible for the fair presentation of financial statements in conformity with generally accepted accounting principles. To meet this responsibility, management may be viewed as implicitly or explicitly making the following assertions (summarized from Figure 5.1):
Assertions about Account Balances (Accounts) |
Assertions about Classes of Transactions and Events |
Assertions about Presentation and Disclosure (Disclosures) |
1. Existence |
1. Occurrence 2. Completeness |
1. Occurrence 5. Classification and |
In the text we combine the assertions as:
a. Existence or occurrence—Assets, liabilities, and equity interests exist and recorded transactions and events have occurred.
b. Rights and obligations—The client holds rights to the assets, and liabilities are the obligations of the company.
c. Completeness—All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded.
d. Valuation, allocation and accuracy—All transactions, assets, liabilities, and equity interests are included in the financial statements at proper amounts.
e. 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.
3. In performing an audit, auditors seek to restrict audit risk—the possibility of issuing an unqualified opinion on financial statements that are materially misstated. Audit risk consists of the risk of material misstatement of a relevant assertion and (2) the risk that the auditors do not detect such misstatement.
a. The risk of material misstatement is composed of two components: inherent risk—the possibility of a material misstatement occurring in an assertion, assuming no internal control; control risk—the possibility that the internal control over an assertion will not prevent or detect a material misstatement.
b. The risk that the auditors do not detect such misstatement is referred to as detection risk—the possibility that the auditors' procedures will not detect the material misstatement.
The audit process involves assessing the risk of material misstatement (inherent and control risk) for each assertion and designing tests to appropriately limit the level of detection risk. The risk of misstatement may be directly assessed, or the inherent and control risk components may be assessed individually.
4. The very nature of some accounts makes the inherent risk of misstatement of those accounts greater than for others. Inherent risk also varies by the type of transactions involved:
a. Routine transaction A transaction for a recurring financial activity recorded in the accounting records in the normal course of business, such as sales, purchases, cash receipts, cash disbursements and payroll.
b. Nonroutine transaction A transaction that occurs only periodically, such as counting and pricing inventory, calculating depreciation expense, or determining prepaid expenses.
c. Estimation transaction A transaction involving management’s judgments or assumptions, such as determining the allowance for doubtful accounts, establishing warranty reserves, and assessing assets for impairment.
Often, nonroutine and estimation transactions have higher inherent risk than routine transactions. However, circumstances may also cause routine transactions to have high inherent risk.
5. The relationships among inherent risk, control risk, and detection risk may be described by the following formula:
Audit Risk = Risk of Material Misstatement x Detection Risk
Audit risk = Inherent Risk x Control Risk x Detection Risk
6. The auditors must obtain sufficient appropriate audit evidence to support their opinion. Sufficiency is a measure of the quantity of audit evidence that must be obtained; appropriate is a measure of the quality of that audit evidence—both its relevance and reliability in providing support for, or detecting misstatements in, financial statements.
7. Although there are sometimes exceptions, audit evidence is ordinarily more reliable when it is:
a.. Obtained from knowledgeable independent sources outside the client company rather than nonindependent sources.
b. Generated internally through a system of effective controls rather than ineffective controls.
c. Obtained directly by the auditor rather than indirectly or by inference (e.g., observation of application of a control is more reliable than an inquiry to the client concerning the control). When auditors obtain evidence from independent sources outside the client company, the reliability is increased.
d. Documentary in form (paper, electronic media, or other media) rather than an oral representation.
e. Provided in the form of original documents rather than photocopies or facsimiles.
8 Auditors must gather sufficient evidence to serve as the basis for an opinion. While auditors must be reasonably certain before expressing an opinion, they are never completely certain. The extent of the evidence needed to support the auditors' opinion for a given audit is a matter of professional judgment, requiring the consideration of both materiality and audit risk.
9. The major types of audit evidence may be summarized as:
a. Accounting information system.
Comparison—agreeing or contrasting two different sources of information, such as by tracing or vouching (see below).
Tracing—following a transaction from the source document to the journals and ledgers.
Vouching—establishing the authenticity and accuracy of entries in accounting records by examining source documents.
Inspection—the process of reviewing a document or record.
Reconciliation—the process of establishing agreement between two sets of independently maintained records of the same transactions.
c. Third party representations.
. Confirmation—the process of proving the authenticity and accuracy of an account balance or entry by direct written communication with the debtor, creditor, or other party.
d. Physical evidence.
Physical examination—to view physical evidence of an asset. For example, the auditors may physically examine inventory.
Observationthe process of viewing a client activity. For example the auditors may observe the client's taking of physical inventory.
e. Computations.
Reperformancethe process of repeating a client activity. For example the auditors might reperform a bank reconciliation.
f. Data interrelationships.
Analytical proceduresevaluations of financial information made by a study of expected relationships among financial and nonfinancial data.
g. Client representations.
Inquiriesquestions directed toward appropriate individuals.
10. Auditors perform the following types of audit procedures:
a. Risk assessment procedures—To obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatement.
b. Tests of controls—When appropriate, to test the operating effectiveness of controls in preventing material misstatements.
c. Substantive procedures—To detect material misstatements of relevant assertions. Substantive procedures include (a) analytical procedures, and (b) tests of details of account balances, transactions and disclosures.
Tests of controls and substantive procedures are referred to as further audit procedures because their nature, timing and extent are based on the results of the risk assessment procedures.
11. Every engagement involves a different level of risk that the financial statements contain material errors or fraud, including violations of generally accepted accounting principles. When the risk is higher, the auditors should demand more and better evidence than would normally be required as a basis for an opinion.
12. Analytical procedures involve evaluations of financial information by the study of the relationships among financial and nonfinancial data. For example, financial balances for the current year may be compared to those of prior years, to budgeted levels, or to relevant nonfinancial data, such as units produced or hours of direct labor.
13. If an audit client's operations are comparable to other firms in the same industry, industry averages obtained from financial reporting services provide a valuable source of information for analytical procedures.
14. The process of performing analytical procedures involves: (1) developing an expectation of an account balance, (2) determining the amount of difference from the expectation that can be accepted without investigation, (3) comparing the company's account balance with the expected account balance, and (4) investigating significant deviations from the expected account balance.
15. Analytical procedures must be performed during the planning stage of the audit to direct the auditors' attention to areas requiring special investigation, and in the final review stage of the audit. Also, they may be applied during the audit as substantive procedures to provide evidence about the reasonableness of specific account balances.
16. The quality of the evidence obtained from analytical procedures varies based on the relevance and reliability of the data used for the comparisons, and the plausibility of the relationships.
17. The evaluation of certain assertions in financial statements may require expertise not possessed by the auditors. In such cases, the auditors will rely on the work of a specialist in the appropriate field. In evaluating the reliability of the evidence provided by a specialist, the auditors should investigate the professional qualifications and reputation of the specialist, and assess the risk that the independence of the specialist might be impaired. They also must obtain an understanding of the methods or assumptions used by the specialist.
18. The purposes of client representation letters are to have officials of the client acknowledge their primary responsibility for the representations made in the financial statements and to get in writing the important oral representations made by these individuals during the course of the audit.
19. The representation letter should be dated as of the last day of field work, and signed by officers that are knowledgeable of, and responsible for, the representations made (e.g., the chief financial officer and the chief executive officer). Management's refusal to furnish written representations constitutes a scope limitation that should preclude the issuance of an unqualified opinion.
20. Gathering evidence in the areas of accounting estimates, fair market values, and related party transactions is difficult because judgments need to be made by both management and the auditors. The three basic approaches for accounting estimates are (a) review and test management’s process of developing the estimates; (b) independently develop an estimate to compare to management’s estimate; and (c) review subsequent events or transactions bearing on the estimate. A combination of the three approaches is often used.
21. Fair market values are used for a variety of accounts (e.g., investments, intangible assets, derivates, impaired assets). When there are no organized market for the assets, management must develop models to estimate their fair values. In these cases, the approaches used to audit estimates (above) are often used to establish the reasonableness of the estimated fair values.
22. Related party transactions are exchanges in which one of the parties has the ability to significantly influence the actions of the other party. Examples of related party transactions include transactions between a company and its officers, directors, major stockholders, or unconsolidated subsidiaries.
23. The primary concern of the auditors is that related party transactions are adequately disclosed in the client's financial statements, including a description of the transactions, the relationship between the parties, and the dollar amounts involved.
24. In auditing for related party transactions, the auditors should make inquiries of management as to the policies and procedures for identifying and accounting for such transactions. They should identify related parties early in the engagement and be alert throughout the audit for evidence of transactions with these parties. The auditors should also investigate any unusual transactions for indications of involvement by related parties.
25. An audit is coordinated and documented with audit documentation (working papers). The information in the working papers constitutes the principal evidence of the auditors' work and their resulting conclusions.
26. The auditors encounter different business organizations and internal control. Therefore, the auditors must tailor the form and content of their working papers to fit the circumstances of each engagement.
27. The primary objectives of audit documentation (working papers) are to provide the principal support for the representation that the auditors performed their audit in accordance with GAAP and to serve as well as support for the audit opinion. In addition to these primary objectives, audit documentation (1) assists team members in planning and performing the audit and serves as a record of matters of continuing significance, (2) assists team members responsible for supervision in reviewing the work, (3) demonstrates the accountability of various team members for the work, and (4) assists others in performing their roles (e.g., quality control reviewers, inspection reviewers, successor auditors).
28. Audit working papers are the property of the auditors. However, much of the information in working papers is confidential, and generally must not be made available to outsiders without the consent of the client.
29. Working papers must be safeguarded from employees of the client during the audit. Safeguarding working papers means keeping them locked in a briefcase during lunch and after working hours.
30. If the auditors are charged with negligence, their working papers will be a major factor in refuting or substantiating the charge. Working papers including conflicting evidence or conclusions make it more difficult for the auditors to protect themselves in court. The Sarbanes-Oxley Act of 2002 requires that auditors retain working papers for a period of not less than seven years.
31. The ultimate responsibility for decisions regarding complex accounting or auditing rests with the engagement partner. However, if other members of the audit team disagree with the resolution of a problem, they should document their disagreement in the working papers.
32. The major types of audit working papers include (1) audit administrative working papers, (2) working trial balance and lead schedules, (3) adjusting journal entries and reclassification entries, (4) supporting schedules, analyses, reconciliations, and computational working papers, and (5) corroborating documents.
33. Audit administrative working papers aid the auditors in the planning and administration of engagements, and include audit plans, programs, time budgets, internal control questionnaires and flowcharts, and engagement letters.
34. The working trial balance is a schedule listing the balances of accounts in the general ledger for the current and previous year, with columns for adjusting entries, reclassification entries, and the financial statement amounts.
35. A lead schedule is used to combine several amounts which total to an amount on the trial balance.
36. The auditors usually maintain two files of working papers for each client: (1) current files for each year's engagement, and (2) the permanent file of relatively unchanging data. The current file pertains solely to that year's examination, while the permanent file contains such things as copies of the articles of incorporation which are of continuing audit interest.
37. Auditors are given 60 days after the audit report date to complete the audit working papers. After the close of thee 60 day period, referred to as the documentation completion date, no information may be deleted from audit working papers. New information may be added, but only with proper documentation of when and who made the changes, the reasons for the changes, and the effect, if any of the changes on the audit conclusions.
38. Working papers should meet the basic objectives of being complete but free of nonessential data and organized in a manner that makes them readily understandable to others. Also, working papers should usually possess the following characteristics:
a. Every working paper must be identified as to client, audit date, and title.
b. A separate working paper should be prepared for each topic.
c. Every working paper should contain the name or initials of the auditor preparing it, the date prepared, and the initials of the auditors reviewing the working paper.
d. All working papers should be indexed to permit systematic cross‑referencing within the working papers.
e. The source of all data should be clearly indicated.
f. The nature and extent of the audit procedures performed should be indicated on the working papers.
g. Whenever tick marks are used, they must be accompanied with a legend explaining their significance.
h. When appropriate, the auditors should write a conclusion on individual working papers indicating how the results will affect the audit report.
39. Many CPA firms prepare electronic working papers. Electronic working papers have the advantage of automatic adjustment of other working papers when a related working paper is changed.
Test Yourself on Chapter 5
True or False
For each of the following statements, circle the T or the F to indicate whether the statement is true or false.
T F 1. A company's financial statements are the representations and assertions of the company's management.
T F 2. Audit evidence may be defined as any information that corroborates or refutes a premise.
T F 3. If strong internal control exists in a client company, then evidence obtained internally is much stronger than evidence obtained from sources outside the client company.
T F 4. The risk that auditors may overlook material misstatement and issue an unqualified report when one is not warranted is the same from one engagement to the next.
T F 5. Strong internal control will increase the reliability of certain types of evidence and reduce the overall quantity of substantive procedures performed by the auditors.
T F 6. Valuation of equipment carried at $70,000 could best be established by physically inspecting the equipment.
T F 7. A confirmation by a customer of an account receivable would be more reliable evidence than the confirmation of the amount of petty cash by the petty cash fund custodian.
T F 8. As a general rule, evidence about the existence of assets is considered most reliable when it is provided by the employee or department with custody of the related assets.
T F 9. Oral evidence is sufficient by itself if it comes from a top corporate officer.
T F 10. A client representation letter helps to remind the client officers of their primary and personal responsibility for the financial statements.
T F 11. Analytical procedures are only useful at the end of the engagement as a final overview of the audited figures.
T F 12. Because CPA firms need an adequate return on their time and investment, cost tends to be the primary factor influencing the auditors in deciding what evidence should be obtained.
T F 13. Some high‑risk auditing situations would include clients with weak internal control, unsound financial condition, or unreliable management.
T F 14. Related party transactions have in common that they all result from dealings between parties related due to ownership interests.
T F 15. Audit working papers should provide primary support from the client's financial statements.
T F 16. The information contained in the auditors' working papers constitutes the principal evidence of the auditors' work and their resulting conclusions.
T F 17. Auditors own the working papers, but they must turn any of them over to the client if the client requests them.
T F 18. Audit working papers generally provide evidence of compliance with the first two standards of field work, but not the third.
T F 19. Working papers should be kept for no more than three years because of the cost of storage.
T F 20. Income statement accounts should not be included on the working trial balance if the accounts have been closed to retained earnings.
T F 21. A copy of a long‑term lease agreement should be filed in the permanent file.
T F 22. Working papers should be initialed by the auditor preparing the working paper and the auditors reviewing the working paper.
T F 23. Reclassification entries are used to correct for the effects of errors or fraud discovered in the client' s financial statements and accounting records.
T F 24 Working papers should never be prepared by the client's personnel.
T F 25. No audit working papers may be discarded after the date of the audit report.
Completion
Fill in the necessary words to complete the following statements.
1. The term __________ relates to the quantity of evidence that the auditors should obtain.
2. The amount of evidence that is considered sufficient varies __________ with the reliability of the evidence.
3. The risk of material misstatement is composed of two risks that the auditor assesses, those risks are __________ risk and __________ risk.
4. __________ __________ __________ and __________ __________ are referred to as “further audit procedures.”
5. The study of trends, percentage changes, ratio, and other relationships among financial and nonfinancial data is termed __________ __________.
6. A __________ is a type of documentary evidence created outside the client organization and transmitted directly to the auditors.
7. In relying upon the work of a specialist, the auditors must ascertain the professional __________ and reputation of the specialist and review the reasonableness of the underlying __________ made by the specialist.
8. A letter signed by officers of the client company at the auditors' request which sets forth certain assertions about the company's financial position and operations is known as a __________ __________.
9. Audit working papers provide evidence that the auditors complied with generally accepted auditing standards, especially the __________ __________ __________ __________.
10. The __________ __________ __________ is a schedule listing the balances of accounts in the client's general ledger.
11. Separate __________ __________ are used to combine similar general ledger accounts into the total that appears on the working trial balance.
12. Working papers of audit interest over an extended period of time should be filed in the __________ __________.
13. The auditors develop __________ __________ to correct the effects of errors or fraud in the client's accounting records.
14. The purpose of an analysis of an account is to illustrate all __________ in the account for the period under audit.
15. Symbols used to indicate the audit work performed on an item are referred to as __________ __________.
Multiple Choice
Choose the best answer for each of the following questions and enter the identifying letter in the space provided.
_____ 1. The major reason auditors gather evidence is to:
a. form an opinion on the financial statements.
b. detect fraud.
c. evaluate management.
d. assess control risk.
_____ 2. Which of the following is not a management assertion?
a. Valuation.
b. Verification.
c. Existence.
d. Rights.
_____ 3. Audit procedures performed to obtain an understanding of the client and its environment, including its internal control, and to assesses the risk of material misstatement are referred to as:
a. analytical procedures.
b. risk assessment procedures.
c. substantive procedures.
d. tests of controls.
_____ 4. Evidence is generally considered sufficient when:
a. it is reliable.
b. there is enough of it to afford a reasonable basis for an opinion on the financial statements.
c. it has the qualities of being relevant, objective, and free from bias.
d. it has been obtained by random selection.
_____ 5. Although there are sometimes exceptions, ordinarily the most reliable audit evidence is:
a from nonindependent sources within the client company rather than independent sources outside the client company.
b. a facsimile of original documents, rather than photocopy.
c. documentary in form rather than an oral representation.
d. generated internally through a system of effective controls rather than through a computerized system of controls.
_____ 6. Analytical procedures are:
a. statistical tests of financial information designed to identify areas requiring intensive investigation.
b. analytical tests of financial information made by a computer.
c. tests that involve evaluations of financial statement information by a study of relationships among financial and nonfinancial data.
d. diagnostic tests of financial information which may not be classified as audit evidence.
_____ 7. A principal purpose of a representation letter from management is to:
a. serve as an introduction to company personnel and authorize the auditors to examine the records.
b. remind management of its primary responsibility for the financial statements.
c. substitute for other evidence‑gathering audit procedures.
d. confirm management's approval of the work performed by the auditors.
_____ 8. When an examination is made in accordance with generally accepted auditing standards, the independent auditors must:
a. use statistical sampling.
b. employ analytical procedures.
c. test internal control.
d. observe the taking of physical inventory on the balance sheet date.
_____ 9. Which of the following procedures is not customarily used by the auditors in determining the existence of related parties?
a. Inquire of customers, suppliers, and employees as to their knowledge of related‑party transactions.
b. Review prior years' work papers for the names of known related parties.
c. Evaluate the company's procedures for identifying and properly accounting for related‑party transactions.
d. Inquire of appropriate management personnel as to the names of all related parties and whether there were any transactions with these parties during the period.
_____ 10. Which of the following eliminates voluminous details from the auditors' working trial balance by classifying and summarizing similar or related items?
a. Account analyses.
b. Supporting schedules.
c. Control accounts.
d. Lead schedules.
_____ 11. Which of the following is not a factor that affects the independent auditors' judgment as to the quantity, type, and content of working papers?
a. The timing and the number of personnel to be assigned to the engagement.
b. The nature of the financial statements, schedules, or other information upon which the auditors are reporting.
c. The need for supervision of the engagement.
d. The nature of the audit report.
_____ 12. The auditors' working papers will generally be least likely to include documentation showing how the:
a. client's schedules were prepared.
b. engagement had been planned.
c. client's internal control structure had been considered.
d. unusual matters were resolved.
_____ 13. The permanent file of the auditors' working papers generally should include:
a. time and expense reports.
b. names and addresses of all audit staff personnel on the engagement.
c. a copy of key customer confirmations.
d. a copy of the corporate charter.
_____ 14. The third general auditing standard requires that due professional care be exercised in the performance of the audit and preparation of the report. The matter of due professional care deals with what is done. For example, due care in the matter of working papers requires that working paper:
a. format be neat and orderly and include both a permanent file and a general file.
b. content be sufficient to provide support for the auditors' report, including the auditors' representation as to compliance with auditing standards.
c. ownership be determined by the legal statutes of the state where the auditors practice.
d. preparation be the responsibility of assistant accountants whose work is reviewed by senior accountants, managers, and partners.
_____ 15. Differences of opinion between members of the audit staff about auditing matters should:
a. never be documented in the working papers because to do could lead to legal liability problems.
b. be documented along with the manner in which they were resolved.
c. be included in a note to the financial statements.
d. be described in the auditors' report.
_____ 16. Tracing a sample of documents from the source documents to the ledgers is designed to test the financial statement assertion of:
a. completeness.
b. validity.
c. existence.
d. valuation.
Exercises
1. Match the following audit terms with their definitions.
_____ 1. Inspection |
a. Proving the accuracy of a client-performed activity. |
_____ 2. Physical Examination |
b. Establishing the validity of a balance by direct communication with an outside party. |
_____ 3. Confirmation |
c. Following a transaction from a source document to recorded entries. |
_____ 4. Reperformance |
d. Observing assets that have physical existence. |
_____ 5. Reconciliation |
e. Establishing the validity of a transaction by examining supporting documents. |
_____ 6. Tracing |
f. Establishing the agreement between two sets of related accounting records. |
_____ 7. Vouching |
g. Critical review of a document. |
2 Analytical procedures must be used by auditors in planning audit engagements.
a. Define analytical procedures.
b. List the two major benefits derived from using analytical procedures in planning an engagement.
(1)
(2)
3. The auditors have two types of working paper files, the current file (CF) and the permanent file (PF). Using the initials and the spaces provided, indicate which file each of the following documents would most likely be filed.
_____ 1. A lease agreement.
_____ 2. A confirmation of financial institution deposits.
_____ 3. Articles of incorporation.
_____ 4. An analysis of long‑term debt.
_____ 5. A pension agreement.
_____ 6. An adjusted trial balance.
_____ 7. Adjusting journal entries.
_____ 8. An analysis of miscellaneous expenses.
_____ 9. An analysis of owners' equity accounts.
_____ 10. A chart of accounts.
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