OVERVIEW
Objective
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To identify the financial statement assertions, sources of evidence and their relationship to critical audit objectives.AUDIT EVIDENCE
APPROPRIATE SUFFICIENT
OBTAINING
¾ Factors ¾ Relevance
¾ Reliability
¾ Directional testing
¾ Where from
¾ Procedures
¾ Examination skills
Understanding
the entity controls Tests of Substantive procedures
¾ Basic principle
1
AUDIT EVIDENCE
[ISA 500]
1.1
Basic principle
Sufficient appropriate audit evidence should be obtained, from which reasonable conclusions can be drawn, as a basis for the audit opinion.
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Sufficiency is the measure of the quantity of evidence; appropriateness is the measure of the quality.¾
The quantity of audit evidence is related to the risk of misstatement and to the quality of that evidence: the higher the risk, the more audit evidence required (which is not the same as
saying the more the better – quality is important as well);
the higher the quality of the evidence, the less that may be required to confirm an
objective.
1.2
Sources
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Audit evidence is all the information used by the auditor in arriving at the conclusions on which the audit opinion is based. All evidence will have a source. Sources may be: internal or external to the entity (eg originating within the entity or externally); oral or written;
direct or indirect (direct to the auditor from an external source or via the client); generated by the auditor (eg analytical review).
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For example, documentary evidence may be: generated and provided to auditors by a third party (i.e. external and independent
(direct) of the entity, e.g. bank confirmation letters which are sent direct to the auditor);
generated by a third party and held by the entity (i.e. external but not independent
(indirect) of the entity, e.g. bank statement);
generated and held by the entity (i.e. internal and indirect, e.g. bank reconciliations
carried out every month by the cashier).
Example 1
Use the following ideas list to generate examples of sources of evidence relevant to the audit of tangible non-current assets.
Solution
1.2.1 Nature of evidence 1.2.2 Examples
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Accounting systems¾
Documentation¾
Tangible assets¾
Management and employees¾
Customers and suppliers¾
Other third parties (e.g. banks, solicitors)¾
Analytical procedures2
SUFFICIENT — A MEASURE OF QUANTITY
2.1
Factors to consider
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How long is a piece of string? That will depend on the job it is required to do. Too short, and the job cannot be completed. Too long, and resources have been wasted.¾
Consider auditing as a jigsaw – all the pieces fit together to show you the whole picture.But the whole picture is not needed – by putting sufficient pieces together in the right places you will be able to say, with reasonable assurance, what you believe the picture to be.
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With the audit, sufficiency factors to consider include: Audit (and engagement) risk as derived from understanding the business, its
environment and controls, eg the higher the risk of a material misstatement, the more evidence that may be required (extent, nature and timing).
Nature of internal control, computerised or manual, eg if computerised a
programmed control will be consistent, manual controls may not be consistent (thus more testing required). Conversely, testing 100% through using CAATs (see Session 21) will be very cost and time effective.
Reliance on effective controls, eg preliminary understanding and as evaluated
Auditors’ (cumulative) knowledge and experience (“CAKE”), eg a first year audit
will always be high risk but as a greater understanding and experience of the client are gained and a more effective and efficient audit approach developed, the level and detail of evidence required may reduce.
Materiality of items; immaterial items require little, if any, evidence, eg just an
analytical review for reasonableness. But remember, for example, that whilst IFRS only applies to material items, what is not material to one client may be very material to another. Materiality is a relative term.
Audit findings (e.g. errors may require further audit work to be carried out). Source and reliability of information (i.e. persuasiveness).
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Difficulty or expense is NOT a valid reason for omitting a necessary procedure. If audit evidence is not sufficient, the implications for the audit opinion must be considered, eg if inspecting assets for existence is considered difficult (eg they are on board ship in the middle of an ocean) other sufficient evidence should be obtained (eg loadingdocuments, insurance documents, confirmation from shipping agents or inspection when landed).
3
APPROPRIATE
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Appropriateness is inter-related with sufficiency (if evidence is not appropriate, sufficiency cannot be achieved) and has two aspects in the context of audit evidence.APPROPRIATE
RELEVANT RELIABLE
3.1
Relevance
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Evidence is required to support the financial statement assertions of management (explicit or otherwise) regarding recognition, measurement, presentation and disclosure of the various elements of the financial statements. These assertions are split into three categories: classes of transactions and events (i.e. primarily statement of comprehensive
income);
account balances (i.e. primarily statement of financial position); presentation and disclosures.
3.1.1
Transactions and events
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Occurrence—transactions and events that have been recorded have occurred and pertain to the entity.¾
Completeness—all transactions and events that should have been recorded have been recorded.¾
Accuracy—amounts and other data relating to recorded transactions and events have been recorded appropriately.¾
Cut-off—transactions and events have been recorded in the correct accounting period.¾
Classification—transactions and events have been recorded in the proper accounts.3.1.2
Balances
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Existence—assets, liabilities, and equity interests exist.¾
Rights and obligations—the entity holds or controls the rights to assets, and liabilities are the obligations of the entity.¾
Completeness—all assets, liabilities and equity interests that should have been recorded have been recorded.¾
Valuation and allocation—assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.3.1.3
Presentation and disclosure
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Occurrence and rights and obligations – disclosed events, transactions, and other matters have occurred and pertain to the entity.¾
Completeness – all disclosures that should have been included in the financial statements have been included.¾
Classification and understandability – financial information is appropriately presented and described, and disclosures are clearly expressed.¾
Accuracy and valuation – financial and other information are disclosed fairly and at appropriate amounts.3.1.4
Assertion mnemonic COMPARE
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Completeness – there are no unrecorded assets, liabilities, transactions, events or disclosures.¾
Occurrence – all disclosed items (events, transactions, disclosures and other matters) actually took place, and relate to the entity, during the period.¾
Presentation and disclosure – all items are disclosed, classified and described in accordance with the applicable financial reporting framework.¾
Allocation and valuation – concerns recording of the valuation of assets, liabilities and equity interests and the correct accounting treatment of subsequent measurement (e.g. valuations and impairments).¾
Rights and obligations – an asset or liability relates to the entity at a given date.¾
Existence – an asset, liability and equity interest exists at a given date.⇒ Mnemonic COMPARE for all assertions with CAPER for assets and liabilities and
COMP for transactions and events
NOTE: Do NOT use mnemonics in the exam, the marker may not know what COMAPRE or CAKE mean! Use them to help you remember the key points (of course it does not help if you remember COMPARE but cannot recall what it stands for).
3.2
Reliability
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The key assertions for any information used by the auditor when considering reliability of audit evidence are the accuracy and completeness of that information, e.g.completeness of a population of documents that are to be sampled; the accuracy of the inventory records when considering reliance on perpetual inventory systems.
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Obtaining evidence about the completeness and accuracy of information may be obtained concurrently when carrying out other audit procedures, or, for example, by using alternative techniques, e.g. CAATs.3.2.1
General presumptions
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External (independent) sources are more reliable than entity (internal) sources.¾
Information generated by the entity (e.g. accounting records) is more reliable whenrelated internal controls are effective.
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Auditor obtained information is more reliable than indirectly obtained (e.g. direct observation by the auditor of the operation of a control, rather than inquiry about the application of that control).¾
Documentary/written information is more reliable than verbal/oral.¾
Original documents are more reliable than photocopies, scans, faxes etc.3.2.2
Consistency
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Consistency increases persuasiveness (i.e. provides cumulative assurance).¾
Consistency from different sources increases persuasiveness (e.g. internal evidence corroborated by external sources)3.2.3
Exceptions
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There will always be exceptions to the generalisations above and care must be taken when considering the reliability of audit evidence, e.g.: evidence obtained from an independent external source may not be that reliable if
the source is not knowledgeable and has little experience of the matter being considered;
original documents may not be available, only their electronic copies. But if the
controls over creation, maintenance and security of the copies are strong, the copies become more reliable.
Example 2
Rank the following items of audit evidence concerning the ownership of land, using a scale of 1 (for worst) to 4 (for best).
Solution
Rank
(1) Ask management if the client company owns the land. (2) Phone bank and ask if they hold title deeds on client’s behalf. (3) Visit bank and examine title deeds.
(4) Ask bank for written confirmation that they hold deed.
3.3
Direction of testing
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The assertion(s) for which evidence is sought influences the source of evidence and direction of testing. It is important to understand the source of evidence required and the direction of the test to ensure the evidence obtained is reliable.¾
Directional testing is based on the premise that: every Dr has a Cr. If an error is found in a Dr item (eg receivables overstated) then
there should be a corresponding error in a Cr item (eg sales overstated, being the natural Dr/Cr entry) or a complementary error in another Dr item (eg Cr entry in expenses, being a misposting, deliberate or otherwise); and
experience has shown that errors within financial statements usually result in Dr
items (eg, assets and expenses) being overstated and Cr items (eg liabilities and income) being understated.
3.3.1
Overstatement
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If the audit risk assessment (derived from business risk) considers overstatement of a balance (e.g. an asset) or class of transactions (e.g. a cost) to be a possibility, then the direction of testing will be FROM the financial statements (where the overstated item is recorded) TO the supporting evidence (eg to collaborate existence and/or the recorded value).¾
By testing for overstatement (from a balance, recorded transaction or disclosure to evidence supporting that item) the item is being tested for assertions relating to: occurrence, cut-off, accuracy and classification of transactions; existence, valuation and rights to assets;
occurrence, accuracy, valuation, classification and understandability of presentation
and disclosures.
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For example, existence of plant and equipment. Agree balance in financial statements to independent analysis, eg plant register
(that is FROM the statement of financial position).
Select material items (plus selection of others) from the register (as if a material item
does not exist, a material error has been found) and trace to the physical asset (that is TO evidence that the asset exists). If the asset cannot be found, then there is an overstatement error in the financial statements.
This will mean that there is a corresponding error in another account or accounts.
In this case it is likely to be understatement of cash (on the basis that the asset has, for example, been stolen) an overstatement of accumulated depreciation (as the asset does not exist) and a misstatement in profit & loss (on disposal of the asset)
3.3.2
Understatement
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If the risk is understatement of a balance or class of transactions, the direction of testing is FROM the source TO the financial statements. This form of directional testing is the most difficult as the appropriate source must be identified.¾
The source may not be (and is often not) monetary, eg issues of material from inventory. When selecting items from such populations for tracing through a system it is important to test the source for completeness. If any items are missing, then there is an immediate potential understatement, eg a missing goods despatch note may not have beenprocessed through the system to produce a sales invoice.
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For example, disposal of non-current assets. The client may give the auditor a list of non-current assets disposed of showing
NBV and value received. As disposals are credit items, disposals cannot be selected from the list and traced to evidence of that disposal – that is overstatement testing as the test is from the schedule to the evidence. By definition, any disposal that is not recorded on the list (hence an understatement) cannot be selected as it is not recorded on the list. A reciprocal population has to be found from which to start the test.
Select a sample of assets (including all material items) from the opening year asset
register plus additions in the year. If no assets were disposed of during the year, all of these assets should be in existence at the year end.
Inspect for existence. If the asset cannot be found, agree if recorded on the list of
disposals provided by client. If not on the list, seek evidence of sale after year end.
If no evidence, then understatement of disposal.
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Note that this test covers both elements (existence and completeness of disposal recording) from one source (the asset register) by selecting items and testing for existence (overstatement if not found) and if they cannot be found, follow through to disposals (understatement of disposals if not on list). This is usually not the case for other areas and care must be taken in selecting the correct approach, direction and items.3.3.3
Understanding
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It is important to understand the objective of the test to be carried out, e.g. overstatement or understatement. For example, if information is provided by the client, is the objective of the testing
of that information to see if anything is missing (understatement) or if something is there that should not be (overstatement)?
If understatement, the auditor must determine the source of that information (or an
independent source) and test to see that everything from that source, that should be included in the financial statements, has been. This is not the same as agreeing what is on the list back to supporting evidence – that is overstatement testing.
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Whilst the basic approach is to test Dr items for overstatement and Cr items forunderstatement, if the identified planning risk is that Dr items may be understated, then they must be tested directly for understatement.
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Some balances may be net balances of Dr and Cr items, eg receivables (Dr gross receivables less Cr bad debt allowance) and non-current assets (Dr opening balances plus additions less Cr disposals and depreciation charge). Directional testing should be applied to all elements.Illustration 1 — Sales transaction testing
Sales system Order
Goods Despatch Note
Invoice
Sales Day Book (Journal)
Ledger account(s)
Testing receivables for existence Testing sales for
completeness
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Normally the risk of sales would be understatement (Cr) – controls are in place to ensure that all goods and services provided will be correctly invoiced and recorded. This would be an understatement transaction test starting from the source, in this case the sales order or despatch note.¾
In other situations, the inventory records may be a more effective place to identify goods despatched, or, if the goods are unique and have to be purchased when a sales order is received (e.g. motor vehicles) then tracing the sale from a purchase invoice would be the most effective way to test sales.¾
Where the risk assessment shows that overstatement of sales throughout the year is a high risk, then the direction of the transaction test would be from the financialstatements, i.e. did the sale actually take place and is supported by an invoice, despatch note and entry in the inventory records.
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If the risk of overstatement is primarily due to cut-off, e.g. January sales being recorded as December year end sales, then the auditor would also derive audit evidence from standard cut-off testing of year end balances.4
OBTAINING
4.1
Where from
TESTS OF
CONTROL SUBSTANTIVE PROCEDURES
UNDERSTANDING THE ENTITY
.… risk assessment procedures include understanding internal control …. suitability of design and implementation ….
…. effectiveness
of operation …. . . . to detect material misstatements in financial
statements …
4.1.1
Understanding the entity
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Risk assessment procedures do not, by themselves, provide sufficient appropriate audit evidence. They must be supplemented with tests of control and/or substantiveprocedures.
4.1.2
Tests of control
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Tests of controls are necessary in two circumstances: when the auditor’s risk assessment includes an expectation of the operating
effectiveness of controls;
when substantive procedures alone do not provide sufficient appropriate audit
evidence (e.g. highly automated systems).
4.1.3
Substantive procedures
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Sufficiency and appropriateness should be considered in relation to: evidence from risk assessment procedures;
evidence from tests of control effectiveness (if any); and financial statement assertions.
4.2
Procedures
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The basic procedures for gathering evidence are: Inspection Observation Inquiry Confirmation Recalculation Reperformance
Analytical procedures.
Example 3
Distinguish between and give examples of the following procedures.
Solution
Description/Examples
Inspection
Observation
Inquiry (or Enquiry)
Confirmation
Recalculation
Reperformance
4.3
Examination skills
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Four basic steps – assertions, direction of testing, accounting entries, procedures.4.3.1
Financial statement assertions
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Consider “relevant” audit evidenceExample 4
Suggest substantive audit evidence for additions to plant and equipment.
“Prompt” ⇒ COMPARE
Completeness –
Occurrence –
Measurement –
Presentation and
disclosure –
Appropriate carrying
value –
Rights (and obligations) –
Existence –
4.3.2
Direction of testing and assertions
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Consider the flow of accounting information and the assertion objectives.¾
It is critical in the examination, that when a test is suggested, that the assertion being tested is also explained. Always explain why the test is being carried out – its objective. Do not just say “inspect invoice” as this may mean you are inspecting it to find out what colour it is. Say what on the invoice you are inspecting and why – what are youExample 5
Suggest audit tests for a factory payroll expense.
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Payroll is an expense, therefore a debit entry. If the assertion objective is that the expense is not overstated as recorded (i.e. payment is only made for services received) then consider:Ledger account(s)
Payroll/payslips
Clockcards
Financial statements – – – – – – – – –
4.3.3
“T” a/c
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Consider the accounting entriesIllustration 2
Receivables control account.
Receivables Control
$ $
Opening balance x Cash received x
Sales x Bad debts written off x
Closing balance x
_ _
x x
_ _
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Establish assertion objectives, e.g. overstatement of receivables, understatement of bad debts (if bad debts are understated, receivables will be overstated).¾
Note that when looking at the Sales account, the key assertion will be completeness (understatement) of sales as it is a Cr entry. Thus sales would have been tested for both under and over statement.¾
This approach is effectively testing for cut-off, eg for receivables: In the control account, trace sales before the year end back to despatch evidence to
ensure goods were despatched before the year end. If not, overstatement of receivables and sales (on the basis that the sales entry would have also been made before the year end).
From cash receipts records, agree cash received before the year end is recorded
before the year end in the control account. If after the year end, receivables are overstated.
Note that bad debts would initially be tested for overstatement as it is a Dr entry in
the P&L. The use of bad debt write-off is a common way of covering up
misappropriation of cash received from debtors (ie cash is understated). By then tracing all valid write-offs through to the receivable control account to ensure recorded in the correct period, receivables are tested for overstatement if the bad debt is not recorded in the correct period.
4.3.4
Procedures
Example 6
Suggest audit procedures for trade receivables.
Solution
Analytical procedure –
Inquire –
Inspect –
Observe –
Recalculation –
FOCUS
You should now be able to:
¾
explain the assertions contained within the financial statements;¾
explain the use of assertions in obtaining audit evidence;¾
discuss the sources and relative merits of different types of evidence available;¾
discuss the quality of evidence available;¾
explain the principles and objectives of transaction testing, account balance testing and disclosure testing.EXAMPLE SOLUTION
Solution 1 — Sources of evidence for tangible assets
Examples
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Accounting systems Tangible asset register¾
Documentation Capital expenditure requisition (assertsauthorisation), purchase invoices (evidence of cost)
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Tangible assets “Kick it“ – land & buildings, plant & equipment, motor vehicles (confirms existence)¾
Management and employees Board minutes (authorisation/capital commitments)¾
Customers and suppliers Lessor (leased assets)¾
Other third parties Bank (for mortgaged/securitised assets)Solution 2 — Ranking evidence
Rank
(1) internal oral. 1
(2) external oral 2
(3) auditor obtained (on originals) 4
(4) external documentary 3
Solution 3 — Procedures
Description/Examples
Inspection (1) Records/documents – manual and electronic
(2) Employees - existence
(3) Tangible assets – non-current assets and inventory existence
Observation Of a process/procedure (e.g. mail opening, physical inventory count)
Inquiry Of knowledgeable persons – written or oral/inside or outside (e.g. bank request) Confirmation Response to inquiry to corroborate info (e.g.
confirmation of trade accounts receivable by communication with credit customers) Recalculation Checking arithmetical accuracy (e.g. source
documents, accounting records, analysis schedules)
Reperformance Independent execution of procedures and controls that were originally performed as part of the entity’s internal control
Use of CAATs to reperform receivables age analysis.
Analytical
Solution 4 — Additions to plant and equipment
Completeness – Review repairs & renewals a/cs in general ledger (for expense of capital nature)
Review disclosures to ensure total of additions appropriately classified
Occurrence – Invoice (date of supply)
Measurement – Purchase invoice (amount – for depreciation thereof and date for cut-off) and correct classification.
Presentation and
disclosure – IAS 16 and IAS 17
Appropriate carrying
value – Depreciation policy – rates and calculations. Revaluation – material change from date of purchase.
Impairment, e.g. self build assets
Rights [and obligations] – Invoice (addressee)/Cash book payment Rights under lease agreement and obligation under finance lease
Existence – (physical) Inspection
Solution 5 — Factory payroll
Ledger account(s)
Payroll/payslips
Clockcards
Financial statements – – – – – – – –
Agree to nominal/(general) ledger a/cs (via trial balance) – inclusion, completeness, classification Check casts/balance – correct, accurate
Agree to payroll summaries – correct, complete Check (a sample of) casts/calculations – valuation, correct
Agree hourly rate to personnel records – correct, accurate
Agree hours worked to clockcards – correct, accurate, occurrence
Confirm authorised – occurrence, complete, accurate
Solution 6 — Trade receivables
Analyticalprocedure – Calculate and compare average collection period (monthly) Enquire – Ask credit controller “What problems are being
experienced in collecting amounts receivable?” Inspect – Sales orders/sales invoices/remittance advices/cash
book receipts – alternative procedures. Observe – Goods despatch to customers/mail opening
procedures
Recalculation – Sales’ ledger balance (and control account balance) – use of CAATs
