Chapter 05

Audit Evidence and

Documentation

McGraw-Hill/Irwin Copyright © 2014 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
 Relevant assertions are those that, without
regard for controls, have a reasonable
possibility of containing a material
misstatement; types
 Assertions about account balances
(Accounts)
 Assertions about classes of transactions and
events (Transactions)
 Assertions about presentation and disclosure
(Disclosures)
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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
 Cutoff—Transactions and events have been recorded in the
correct accounting period
 Valuation, Allocation and Accuracy—All 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 x Risk Auditors Fail

Audit Risk = Misstatement to Detect Material
Misstatement

= Inherent x Control x 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
company’s 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
 Low 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
 Highest inherent risk

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Appropriateness of Audit Evidence

Auditor must obtain sufficient appropriate audit

evidence.
 To be appropriate audit evidence must be:
 Relevant
 Reliable
 Audit 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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Overall Categories 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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 Types of Audit Procedures
1. Inspection of records and documents
2. Inquiry of knowledgeable persons within or
outside the entity
3. External confirmation
4. Inspection of tangible assets
5. Observation of processes or procedures
being performed by others
6. Recalculation of mathematical accuracy.
7. Reperformance of procedures
8. Analytical procedures

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Audit Procedures and Examples
(Figure 5.3)

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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 NET:
• Nature (type and form)
• Extent (quantity of evidence obtained)
• Timing (when performed)

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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 extent of substantive procedures
needed
 The main way to increase the extent of audit
procedures is to examine more items
 Sample sizes should reduce detection risk to
minimize audit risk

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General on Analytical Procedures (1 of 3)

 Timing of analytical procedures

 Risk assessment (sometimes referred to as planning
analytical procedures)
 Substantive procedures
 Final review

 Steps involved
 Develop expectation of account (or ratio) balance
 Determine amount of difference that can be accepted without
investigation
 Compare the company’s account (ratio) with the expectation
 Investigate and evaluate significant differences

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General on Analytical Procedures (2 of 3)

 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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General on Analytical Procedures (3 of 3)

 Types of Expectations
 Trend analysis—analyze 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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Basic Approaches to Auditing Accounting
Estimates
 Review and test management’s
process for developing the estimate.
 Independently develop an estimate
to compare to management’s
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, stockholder’s 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 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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