AUDIT EVIDENCE (ISA 500) Notes

Audit Evidence Revision Questions and Answers

INTRODUCTION

The objective of an audit of the financial statement is for an auditor to express an opinion of the financial and state whether they present a true and fair view of the financial statements. In order for the auditor to do so he needs to gather sufficient and reliable audit evidence. The work of an auditor is used by many users and hence before he comes up with his conclusion he needs to have gathered sufficient audit evidence on which to base his opinion so that whatever decision those users come up with, is the right one. This chapter covers the gathering of that evidence, the methods used and the reliability of that evidence to the auditor amongst many other things. Audit evidence is covered by iSa 500 Audit Evidence.

KEY TERMS Used In Audit Evidence

Audit evidence – refers to the information obtained by the auditor in arriving at the conclusions on which the audit opinion on the financial statements is based.

Substantive procedures – these are audit tests carried out to test the accuracy and validity of the accounting records.

Sufficient appropriate audit evidence– Sufficiency is the measure of the quality of audit evidence while appropriateness is the measure of the quantity of the evidence

Reliability of audit evidence– this refers to the credibility of the source of the evidence

Audit sampling– involves the application of substantive or compliance procedures to less than 100% of items within an account balance or class of transactions to be enable the auditor obtain and evaluate some characteristics of the balance and form a conclusion concerning that characteristic.

INDUSTRY CONTEXT OF AUDIT EVIDENCE

In-order for an auditor to form an opinion on the financial statements, he needs to gather sufficient appropriate evidence on which to base his opinion. The procedures for gathering evidence outlined in this chapter are used on a day to day basis by the auditors, hence, by going through this chapter the student gets a feel on how the auditor goes about the process of gathering the audit evidence.

audit evidence refers to the information obtained by the auditor in arriving at the conclusions on which audit opinion on the financial statements is based. Audit evidence comprises of source documents and accounting records underlying the financial statements. The accounting records generally include:

records of initial entries and supporting records
records of electronic fund transfers, invoices, contracts and cheques.
General and subsidiary ledgers, journal entries and other adjustments to the financial statements not reflected in the journal entries
records such as work sheets and spread sheets supporting cost allocations, computations and reconciliations. other information the auditor can use as audit evidence are:
minutes of meetings
Confirmations form third parties
analysis reports
Comparable data about competitors.
Control annuals.
information obtained by auditor from audit procedure such as observation and enquiries.

The sources and amount of evidence needed to achieve the required level of assurance is determined by the auditor’s judgment. The auditor’s judgment will be influenced by the materiality of item being examined, the relevance and reliability of evidence available from each source and cost involved in obtaining it. audit evidence is obtained through an appropriate mix of tests of controls and substantive procedures where internal control system is considered weak; evidence may be obtained entirely from substantive procedures.

Substantive tests are procedures carried out to test the accuracy and validity of accounting records. They are of two types i.e. analytical review procedure and test of detail.

Qualities of Audit Evidence

ISA 500 requires that ‘the auditor should obtain sufficient audit evidence to be able to draw reasonable conclusions on which to base the audit opinion.’ What do we mean by:

Sufficiency
appropriate

Sufficient means that there needs to be enough evidence. What is enough is a matter of professional judgment. appropriate break down into:

a) Relevance.

relevance of audit evidence should be considered in relation to the overall audit objective of forming an opinion and reporting on financial statements. It therefore refers to the ability of the evidence to assist the auditor in testing management assertions. b) reliability

Reliability of audit evidence refers to the credibility of that evidence the credibility is influenced by its source and its nature

Use of assertions in generating audit evidence

When preparing financial statements the management makes certain implicit or explicit assertions about the financial affairs of the company.

Consequently, when the auditor is obtaining evidence from a substantive procedure, he is concerned about testing or substantiating the truth of these assertions. The assertions are categorized as follows;

Assertions about hinting of transactions and events for the period under audit i.e.
1. Occurrence transaction and events that have been recorded have occurred and pertain to the entity.
1. Completeness
1. Cut off. Transactions and events have been recorded in the appropriate accounting period
1. Accuracy amounts and other data relating to the recorded transactions have been recorded appropriately.
1. Classification. Transactions and events have been recorded in the correct period
Assertions about account balances at the year end.
1. Existence. assets or liabilities exist at a given date
1. Rights and obligations
1. Completeness
1. Valuation and allocation
Assertions about presentation and disclosure.
1. Occurrence and rights and obligation. Disclosed events and transactions and other matters have occurred and pertained to the entity
1. Completeness all disclosures that should have been included e.g. compositions of director’s fees.
1. Measurement and valuation. Financial and other information are disclosed fairly and at appropriate amounts
1. Classification and understandability. Financial information is appropriately presented and described, and disclosures are clearly expressed

The auditor may use the assertions described above or may express them differently provided all aspects described above have been covered .

Methods of Obtaining Audit Evidence

The auditor may rely on sufficient appropriate evidence obtained by substantive testing to form his opinion. alternatively he may be able to obtain assurance from presence of a reliable internal contrast system and therefore reduce the extent of substantive testing the auditor obtains evidence in performing compliance and substantive procedures using the following methods. a) inspection.

This consists of examining records, documents or tangible assets. The reliability of the evidence obtained from inspection depends on nature, source and effectiveness of the internal control system. inspection of tangible assets provides evidence with the respect to the existence but not to their value and ownership.

Observation

This involves looking at procedures being performed by others e.g. stock counting by client personnel.

Inquiry and confirmation.

inquiry consists of seeking information from knowledgeable persons inside and outside the company. it ranges from formal written inquires addressed to the third parties to oral inquiries addressed to persons within the entity. The information may be new to the auditor or may corroborate evidence from other sources. Confirmation is the response to inquiry to corroborate information contained in financial statements e.g. debtors circularization.

Recalculation and re-performance

This involves checking the arithmetic accuracy of source documents and accounting records or performing independent computations e.g. re-computing amount of provision for depreciation and comparing this against that computed by client.

Analytical procedures.

This is the analysis of relationships such as between items of financial data to identify consistency and predicted patterns or significant fluctuations, unexpected relationships and results of investigations thereof.

Analytical Procedures (1SA 520)

Nature and Purpose of Analytical Procedures

They are mainly used at 3 stages of the audit:

as part of the planning process
- At the final review stage
- as substantive procedures analytical procedures are involved in evaluation of financial statements information by a study of relationships among financial and non financial information. A basic premise underlying the application of analytical procedures is that logical or plausible relationship among data may be expected to exist and continue in the absence of conditions to the contrary. Therefore the auditor can use these relationships to obtain evidence of the financial statements amounts. A simple analytical procedure is to compare revenue and expenses amounts for the current year to those of prior periods noting any significant differences. Essentially, the process of performing analytical procedures consists of four steps.
- Develop an expectation of account balance or ratio
- To determine the amount of difference from expectation that can be accepted without investigation
- Comparison of company’s account balances or ratios with the expected.
- Investigate and evaluate significant ratio differences from the expectation

1. Developing an expectation.

a variety of types of information are available to the auditor to develop an expectation for analytical procedures including;

Financial information for comparable priority periods.
anticipated results such as budgets and forecasts.
Relationships among elements of financial information within a period e.g. level of debtors and credit sales.
Information derived from similar firms in the same industry e.g. industry wage average.
Relationships between financial and non financial data e.g. wage expenses and a number of employees. in establishing these relationships, the auditor may use shillings amount, physical quantities ratios or percentages.

To increase the precision of the analytical procedures, separate relationships may be computed for each department or product line. industrial averages provide a potentially rich source of information in developing expectation for analytical procedures, since industry statistics may alert auditors to classification error, improper application of accounting principles or other misstatements in specific items in client’s financial statements. However there may be problems of lack of comparability among companies and inability to obtain current industry data.

Methods of developing expectation on account balances and ratios

Trend analysis. This includes review of changes in an account balance over time e.g. review of clients sales for the past six years may reveal a growth rate of 5%. This information could assist auditor in developing an expectation of sales for the current year.
ratio analysis. This involves comparison of relationships between two or more financial statement account balances or comparisons of an account balance to non financial data e.g. revenue per sale order. The typical financial ratios are liquidity, profitability, leverage and activity ratios. because ratio analysis involves examination relationships between two or more variables and may involve industrial data, it is often a richer analysis than trend analysis. There are two basic approaches to ratio analysis;
horizontal analysis. This involves review of client’s ratios and trends over time
Cross sectional analysis. This involves comparisons of ratios of similar firms at a given point in time.
The amount of acceptable difference.

The amount of acceptable difference between the expectation and the financial statements balance that can be accepted without investigation is determined primarily by the amount that is considered to be a material misstatement However; this amount must be consistent with the degree of assurance from the procedure. When trend or ratio analysis is used, the auditor typically uses professional judgment to specify an absolute amount of difference or percentage difference that will result into investigation.

Comparison of the account balance or ratio with the expected balance or ratio.

once the auditor has determined the expectation and amount of acceptable difference, he makes the actual comparison to determine where significant difference lies.

Investigation and evaluation of significant differences.

The auditor must investigate any significant differences and his expectation and the client’s financial statements balance or ratio to determine whether they represent misstatements. This involves reconsidering the methods and factors used in developing the expectation. inquiry to management can be useful in this regard. management explanations however must be ordinary be supported with other audit evidence. if the explanations are not tallying with other audit evidence, the editor will often be required to expand his tests of related financial amounts to determine whether or not they are materially misstated.

Timing of analytical procedures

iSas require the application of analytical procedures at the planning and overall review stages of the audit. The auditor may also decide to use them during the audit on substantive tests to provide evidence as to the reasonableness of specific account balances. Analytical procedures performed in planning the audit are used to determine the nature, timing and extent of audit procedures that will be used to obtain evidence about specific accounts. They are also used in understanding the client’s business at the planning stage.

analytical procedures must be used as part of the overall review stage of an audit to assist the auditor in assessing the adequacy of the evidence gathered and the validity of conclusions reached. At the final review stage of an audit, the analytical procedures generally include reviewing the financial statements and re-computing ratios if necessary to identify any unusual or unexpected balance or that have not been previously identified and explained.

Where the auditors are not required to use analytical procedure as substantive tests, they are usually most efficient tests of certain assertions .e.g. performing analytical procedures is the most efficient way to evaluate competence of various revenue and expense accounts.

Extent of analytical procedures

auditors must consider cost and likely effectiveness of analytical procedures in determining how much they may be used for a particular audit a primary measure of the effectiveness of analytical procedures is its precision. precision depends on a number of factors including the predictability of the relationship, the techniques used to develop the expectation and the reliability of the underlying data used. monthly data is more precise than yearly data.

Management representations iSA580

Oral representations.

Throughout an audit the auditors ask many questions to the officials and employees of Client Company. oral inquires are made on an endless range of topics from the location of records and document, reasons for unusual account procedures and probability of collecting overdue accounts receivable. in making inquires, the auditor should consider the knowledge, objectivity, experience, responsibility and qualifications of individuals being questioned and use carefully structured questions to address relevant issues. Client replies should be carefully evaluated as appropriate and followed up with additional questions.

Generally, oral client representations are not sufficient themselves but they may be useful in disclosing situations that require investigation or in corroborating other forms of evidence e.g. after making careful analysis of all accounts receivable, the auditor normally discusses with the credit manager, the prospects of collecting specific accounts.

Written representations.

The auditor must also obtain written representations from the client in accordance with provisions of iSa 580. at conclusion of the audit, the auditor obtains from the client a written representation letter. This letter summarizes the most important oral representations made by management during the audit. Many specific items are included in this representation letter e.g. management represents that all liabilities known to exist are reflected the financial statements. The representations generally fall into the following broad categories;

All accounting records, financial data and minutes of director’s meetings have been made available to the auditor.
- The financial statements are complete and were prepared in conformity with generally accepted accounting principles.
- management believes that adjusting entries brought to the attention by the auditor and not recorded are not material individually or collectively.
- all items requiring disclosures such as contingencies, illegal acts and related parties transactions have been properly disclosed. iSa 580 requires the auditor to obtain representations letter on every engagement and provide suggestions as to its form, content and guidance on how it is to be used as audit evidence and actions to be taken if client refuses to provide representations. These letters are dated as of the date of the auditor’s report ordinarily the last day of field work and are usually signed by both the client chief executive officer and the chief accountant. A client representations letter should never be used as a substitute for performing other audit procedures. The financial statements already constitute written representations by the client hence representation letter does little more than assert that the original representations were correct.

Purposes of representations letter

To remind the client’s directors of their primary responsibilities for the financial statements.
- Documents in the audit working papers, client responses to the significant questions asked by the auditor during the engagement.
- at times a representation letter may be the only evidence available in respect to management future intentions e.g. whether a maturing debt is classified as a current or long term liability will depend on whether management has both the ability and intent to refinance the debt.

management may be unwilling to sign letters of representation or pass minutes required by the auditor. if management declines, the auditor should inform the management that he will himself prepare a statement in writing setting out his understanding of any representations that they have been made during the course of the audit and send this statements to management with a request for confirmation that the auditor’s understanding of the representations is correct.

if management disagrees with the auditor’s statement of representations, discussions should be held to clarify the matters in doubt and if necessary a revised statement prepared and agreed. Should management fail to reply, the auditor should follow up the matter to ensure the position as set out in his statement is correct

in rare circumstances, the auditor may be completely unable to obtain written representations which he requires e.g. because of the refusal by management to cooperate or because management declines to give proper representations required on the ground of its own uncertainty regarding that particular issue. in such circumstances, the auditor may have to conclude that he has not received all information and explanations required and consequently may need to consider qualification his audit report an ground of limitation in scope of the audit.

ISA 620 Using the work of an expert

The auditor should obtain sufficient appropriate audit evidence that the work of the expert is adequate for the purpose of the audit.

An expert is a person possessing specialized skills, knowledge and experience in another field other than auditing and accounting. From his experience, an auditor only has general knowledge on matters outside his profession and is not expected to have the skills of a person trained or qualified to work in another profession .Consequently, the auditor may need the advice of another expert for example, a pharmacist when verifying stock in the laboratory or lawyers in arriving at the legal interpretation of legal cases against a client.

Situations where the auditor may require work of an expert

The legal interpretation of contracts, laws and regulations
valuations of certain types of assets e.g. precious stones, minerals and buildings
actuarial valuation e.g. for pension funds
When measuring the work to be completed in construction contracts.

In deciding whether to use the work of an expert the auditor should consider.

The materiality of an item being examined in relation to the financial statements as a whole.
The nature and complexity of the item including the risk.
The audit evidence available in respect with the item.

Factors Considered Before Relying on the Work of the Expert

The auditor should consider;

The skills and competence of the expert. The auditor should consider this by examining the expert’s professional qualifications, licenses or membership of an appropriate professional body. The experience and reputation of the expert in the field in which the auditor is seeking evidence is very important.
Objectivity and independence of the expert.. The auditor should consider whether the expert is independent from the client. The risk of independence being impaired increases where the expert is employed by the client. in such cases he owes his loyalty to the client because there exists a financial relationship.
The source of the data used by the expert in arriving at his opinion. if the source of the data can be regarded as reliable, then the auditor can reasonably use the work of the expert as audit evidence.
The assumptions and methods used. The auditor should consider whether the methods used by the expert in arriving at his opinion are appropriate to the circumstances. he should also obtain an understanding of those assumptions and methods to determine that they are reasonable based on the auditor’s knowledge of the client’s business and the results of his other audit procedures.

Communication with the expert

When consulting an expert the auditor should cover:

objectives and scope of his work
an outline of the item the auditor expects to be covered in the report.
The intended use of the expert work by the auditor and disclosure to third parties as to the expert’s identity and extent of involvement • Clarification of the expert’s relationship with the client.
The confidentiality of the client information.
assumptions and the methods the expert intends to use. These will be evaluated for reasonableness by the auditor.

The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion.

Audit evidence refers to the information obtained by the auditor in arriving at the conclusions on which the audit opinion on the financial statements is based. Audit evidence comprises source documents and accounting records underlying the financial statements and corroborating information from other sources.

Substantive procedures are audit tests carried out to test the accuracy and validity of the accounting records. Substantive procedures are mainly of two types i.e. analytical review procedures and tests of details.

Audit Sampling involves the application of substantive or compliance procedures to less than 100% of items within an account balance or class of transactions to be enable the auditor obtain and evaluate some characteristics of the balance and form a conclusion concerning that characteristic.

The two main approaches that can be applied in sampling are:

Judgmental sampling:
Statistical sampling