Chapter 5 Audit Evidence 1 Audit Evidence CAS

Chapter 5 Audit Evidence - 1

Audit Evidence (CAS 500) • Most of the auditor’s work in forming an audit opinion consists of • CAS 500 explains that audit evidence • Evidence includes Audit Evidence - 2

• Evidence is – information that – Also information that – In some cases, it can be • Evidence is gathered in all phases of the audit process and is used to help the auditor make a variety of judgments and conclusions – to accept – to plan the audit – to decide where there could be a risk – to develop an – to conclude Audit Evidence - 3

Audit Evidence Decisions • NATURE: • EXTENT: • TIMING: Audit Evidence - 4

Importance of NET Audit Evidence Decisions Nature of Audit Procedure Quality Affecting the Persuasiveness of Evidence Appropriateness Relevance Reliability • Obtained directly from the auditor • Independence of source • Qualifications of source • Consistency of evidence • Effectiveness of internal controls • Objectivity of evidence Extent of Testing Sufficiency • Adequate sample size • Selection of proper population items Timing Timeliness • When procedures are performed • Portion of period being audited Audit Evidence - 5

Audit Procedures • What is an audit procedure? – It is the detailed instructions – The actual task that you • Audit procedures fall into three categories: – Risk assessment procedures – Tests of controls – Substantive procedures Audit Evidence - 6

Audit Procedures: Risk Assessment Procedures • For each major class of transactions • Also for each material general ledger account • Knowledge of the client’s industry, business, and operating procedures will help the auditor complete this assessment. Audit Evidence - 7

Which Items to Select for an Audit Procedure • Once an audit procedure is determined, the auditor may: • The choice depends upon the purpose of the test and the particular circumstances • What circumstances? Audit Evidence - 8

The Timing of an Audit Procedure • What time frame does an audit of financial statements usually cover • The timing of audit procedures can vary from early in the accounting period to long after it has ended. Audit Evidence - 9

The Audit Program • What is an audit program? • Normally, there is an audit program for each component of the audit • An audit program includes – – – audit procedures sample size items to select timing the relevant assertion Audit Evidence - 10

Sample Size • The sample size will vary depending upon: • The sampling method and size is related to assessed risks. Audit Evidence - 11

The Persuasiveness of Evidence • Sufficient appropriate • Persuasive evidence is: – Appropriate – Sufficient – Timely Audit Evidence - 12

The Appropriateness of Evidence • Appropriateness or sufficient appropriate evidence means • The auditor must be persuaded that his or her opinion is correct with a high level of assurance. • The sample size will vary depending upon: • The sampling method and size is related to assessed risks. Audit Evidence - 13

Is the Evidence Relevance? • Relevance of evidence deals with the logical connection with the design of the audit procedure and the assertion or control that is being tested. • Relevance can be considered only in terms of specific audit objectives. Audit Evidence - 14

Reliability of Evidence • Six factors: – Evidence obtained directly by auditor – Independence of source (ie. , the information provider) – Qualifications of source (ie. , the information provider) – Consistency from multiple sources – The effectiveness of client’s internal controls – Degree of objectivity Audit Evidence - 15

Sufficiency • The quantity of evidence obtained determines its sufficiency. • Quantity is measured primarily by • The most important factors determining the appropriate sample size are: Audit Evidence - 16

Effect of Internal Controls e. g. Accounts Receivable Balance Sheet Transactions e. g. Income and Expenses Income Statement Internal Controls Audit Evidence - 17

Timeliness • The timeliness of audit evidence can refer to • For balance sheet accounts, when is the evidence is more persuasive • For income statement accounts Audit Evidence - 18

Combined Effect • The auditor needs to consider all of the evidence factors together – i. e. , the combined effects of • Part of the evidence gathering decision is related to the trade-off of the cost of gathering evidence versus its persuasiveness. Audit Evidence - 19

Specific Types of Audit Procedures (1 of 5) • CAS 500 – Audit Evidence (1) (2) (3) (4) (5) (6) (7) Inspection Observation External confirmation Recalculation Reperformance Analytical procedures Inquiry Audit Evidence - 20

Specific Types of Audit Procedures (1) Inspection § literally the auditor’s inspection or count § Inspection is regarded as one of the (2) Observation § observation is the use of one’s senses to assess certain activities. § It is never sufficient by itself Audit Evidence - 21

Inspection: Internal Versus External Documentation • An internal document • An external document • Which one is more reliable? Audit Evidence - 22

Inspection: Vouching and Tracing • Vouching is the use of documentation to support • Tracing is the use of documentation to determine if Trace Original Document Journal or Ledger Vouch Audit Evidence - 23

3) External confirmation 4) Recalculation 5) Reperformance Audit Evidence - 24

6. Analytical procedures 7. Inquiry Audit Evidence - 25

Appropriateness of Types of Procedures • The effectiveness of internal controls has a significant effect on the reliability of most types of evidence. • Both inspection and reperformance are likely to be highly reliable if internal controls are effective. • Some types of evidence are rarely sufficient to provide competent evidence to satisfy an objective. • Consider the cost of the procedure. Audit Evidence - 26

Reliability of Types of Audit Procedures Criteria to Determine Reliability Type of Audit Procedure Independence of Provider Effectiveness of Client’s Internal Control Auditor’s Direct Knowledge Qualifications of Provider Objectivity of Evidence Inspection—Physical Examination High (auditor does procedure) Varies High Normally high (auditor does procedure) High Inspection— Documents and Records Varies—external documents more independent than internal documents Varies Low Varies High Observation High (auditor does) Varies High Normally high (auditor does) Medium Inquiries of the client Low (client provides) Not applicable Low Varies—low to high External confirmation High Not applicable Low Varies—usually high High Recalculation High (auditor does) Varies High (auditor does) High Reperformance High (auditor does) Varies High (auditor does) High Analytical procedures High/low (auditor does/client responds) Varies Low Normally high (auditor does/client responds) Varies—depends on the reliability of the data Audit Evidence - 27

Terms Used in Audit Procedures Eleven Example of terms used when performing audit procedures 1. Examine 2. Scan 3. Read 4. Compute 5. Recompute 6. Foot 7. Trace 8. Compare 9. Count 10. Observe 11. Enquire Audit Evidence - 28

Terms, Audit Procedures, and Types of Evidence Examine A reasonably detailed study of a document or record to determine specific facts about it. Type of audit procedure? Scan A less detailed examination of a document or record to determine if there is something unusual warranting further investigation. Type of audit procedure? Read An examination of written information to determine facts pertinent to the audit and the recording of those facts in a working paper. Type of audit procedure? Audit Evidence - 29

Compute A calculation done by the auditor independent of the client. Type of audit procedure? Recompute A calculation done to determine whether a client’s calculation is correct. Type of audit procedure? Foot An addition of a column of numbers to determine if the total is the same as the clients. Type of audit procedure? Audit Evidence - 30

Trace An instruction normally associated with documentation or reperformance. The instruction should state what the auditor is tracing and where it is being traced from and to. Frequently, an audit procedure that includes the term “trace” will also include a second instruction, such as “compare” or “recompute. ” Type of audit procedure? Compare A comparison of information in two different locations. The instruction should state which information is being compared in as much detail as is practical. Type of audit procedure? Audit Evidence - 31

Count A determination of assets on hand at a given time. This term should only be associated with the type of evidence defined as physical examination. Type of audit procedure? Observe The act of observation should be associated with the type of evidence defined as observation. Type of audit procedure? Inquire The act of inquiry should be associated with the type of evidence defined as inquiry. Type of audit procedure? Audit Evidence - 32

Analytical Procedures, CAS 520 • Analytical procedures are • They may be performed throughout the engagement: 1. In audit planning 2. During the risk response 3. During the completion Audit Evidence - 33

Four Types of Analytical Procedures The auditor typically compares the client’s balances and ratio – Audit Evidence - 34

Some Ratio Examples (but not all) Short-Term Debt-Paying Ability Current ratio = current assets/current liabilities Liquidity Activity Ratios Average A/R turnover = Net credit sales/average accounts receivable Average inventory turnover = COGS/average inventory Audit Evidence - 35

Ability to meet LTD obligations Debt-to-equity = total liabilities/total equity Times interest earned = operating income/interest expense Audit Evidence - 36

Profitability ratios EPS = profit/common stock outstanding Gross margin percent = ((total revenue – COGS)/total revenue) x 100 Audit Evidence - 37

Using Analytical Procedures as Substantive Tests • CAS 520 describes the process of developing substantive analytical procedures: 1. Develop an independent expectation 2. Define a significant difference 3. Compute the difference 4. Investigate significant differences Audit Evidence - 38

Documentation • Audit documentation • The written or electronic record of • Audit documentation is prepared and kept: – – As a basis for As a record of To provide support for Basis for review by Audit Evidence - 39

File Archive: Working Paper Contents and Organization Audit Evidence - 40

Preparation of Working Papers • Working papers should possess certain characteristics: – Each working paper should be properly identified with such information as: § the client’s name § the period covered § a description of the contents § the name of the preparer § the date of preparation § an index code. – Working papers should be – Completed working papers must clearly indicate – Each working paper should include enough information to fulfill the objectives for which it was designed. Audit Evidence - 41

Ownership of Working Papers and Confidentiality of Working Papers • The working papers prepared during the engagement, including those prepared by the client for the auditor • The rules of conduct of the professional accounting bodies require their members Audit Evidence - 42

Effect of Technology on Audit Evidence and Audit Documentation • Audit software – • Auditors often use engagement management software to organize and analyze audit documentation. • Auditors also use Audit Evidence - 43

Professional Skepticism, Evidence, and Documentation • Professional skepticism is an attitude that includes being alert to, for example: Audit Evidence - 44

Problem 5 -23, 14 th. Edition Classify each of the presented audit procedures according to the types of evidence collection procedures: (1) inspection or physical examination, (2) confirmation, (3) document inspection, (4) analytical procedure, (5) inquiries of the client, (6) recalculation, (7) reperformance, and (8) observation. Type of Audit Evidence Audit Procedure Review the accounts receivable with the credit manager to evaluate their collectibility. Compare a duplicate sales invoice with the sales journal for customer name and amount Count inventory items and record the amount in the audit files. Obtain a letter from the client’s attorney addressed to the CPA firm stating that the attorney is not aware of any existing lawsuits. Extend the cost of inventory times the quantity on an inventory listing to test whether it is accurate. Obtain a letter from an insurance company to the CPA firm stating the amount of the fire insurance coverage on buildings and equipment. Examine an insurance policy stating the amount of the fire insurance coverage on buildings and equipment. Calculate the ratio of cost of goods sold to sales as a test of overall reasonableness of gross margin relative to the preceding year. Obtain information about internal control by requesting that the client fill out a questionnaire. Trace the total in the cash disbursements journal to the general ledger. Watch employees count inventory to determine whether company procedures are being followed. Examine a piece of equipment to make sure that a major acquisition was actually received and is in operation. Calculate the ratio of sales commission expense to sales as a test of sales commissions. Examine corporate minutes to determine the authorization of the issue of bonds. Review the total of repairs and maintenance for each month to determine whether any month’s total was unusually large. Obtain a written statement from a bank stating that the client has $15 671 on deposit and liabilities of $500 000 on a demand note. Obtain a letter from management stating that there are no unrecorded liabilities. Audit Evidence - 45

Problem 5 -25, 14 th. Edition According to the Canadian Organic Food Standards, the “organic” label can only be placed on apples that are grown without chemical pesticides. You recently decided to start eating organic apples. However, you heard that an undercover investigation by CBC’s Marketplace has revealed that the organic farm where you want to buy the apples uses chemical pesticides to grow all of their apples. You are now worried that the more expensive “organic” labeled apples that you want to buy might not really be organic. Based on what Marketplace has uncovered, what assertion did the organic farm violate? A. Existence B. Completeness C. Accuracy D. Right & Obligations E. Valuation F. Occurrence For each procedure indicate the reliability level of evidence (low, medium, high) obtained. Procedures Call the organic farm and ask if they use chemical pesticides. Quality of Evidence Low Buy apples grown at the organic farm and taste them to see if you can sense any chemical pesticide. Send a letter to the organic farm asking them to confirm in writing that they did not use chemical pesticides to grow their apples. Contact Marketplace and confirm with them that their story relates to the organic farm where you want to buy the apples. Buy apples grown at the organic farm, take them to a laboratory, and have them tested to see if they contain any traces of chemical pesticides. Audit Evidence - 46

Problem 5 -34, 14 th. Edition You are an audit manager on the year-end audit of Nicolas Manufacturing. Your team was assigned a new junior staff member, Michelle, who recently graduated from university. Michelle performed the following two audit procedures and provided you with a written explanation about the reliability of audit evidence that she obtained as part of each procedure. Procedure #1 To verify the valuation of accounts receivable, I obtained from the A/R manager the Excel schedule where he calculated the year-end adjustment posted to the allowance for doubtful accounts. I reviewed the formulas used in the calculation and recalculated the totals. Since the recalculation was done directly by me (auditor), the reliability of this evidence is high and I confirm that the accounts receivable balance at year-end is valued correctly; no further work required. Procedure #2 To verify the existence of inventory, I attended the year-end inventory count. While walking around the warehouse, I enquired of employees who were taking the count about any possible inventory that could have been missed during the count, such as items located on top shelves. The employees told me that they haven't missed any items. The reliability of this evidence is high as the inquiry was done directly by me (auditor). I confirm that the inventory balance exists; no further work is required. REQUIRED 1. Discuss Michelle’s comments about the reliability of her audit evidence. In your discussion consider if the evidence that Michelle obtained is sufficient to support her conclusions. 2. Review the assertions covered by each procedure. Does Michelle’s work cover the stated assertion? If not, what assertion did Michelle’s work cover? 3. Recommend more reliable evidence that Michelle could obtain to support her conclusions. Audit Evidence - 47

Problem 5 -35, 14 th. Edition Lesley Stopps, a public accountant, is the auditor for Great Western Lumber Company Ltd. , a wholesale wood milling company. Lesley calculated the gross margin for three product lines and compared it to industry information (summarized in the table below). Great Western and Industry Gross Margins 2018 Gross Margin % 2017 Gross Margin % 2016 Gross Margin % Great Western Industry Hardwood 36. 3 32. 4 36. 4 32. 5 36. 0 32. 3 Softwood 23. 9 22. 0 20. 3 22. 1 20. 5 22. 3 Plywood 40. 3 50. 1 44. 2 54. 3 45. 4 55. 6 In discussing the results, the controller told Lesley that Great Western has always had a higher gross margin on hardwood products than the industry because it focuses on the markets where it is able to sell at higher prices instead of emphasizing volume. The opposite is true of plywood where it has a reasonably small number of customers, each of which demands lower prices because of high volume. The controller also told Lesley that competitive forces have caused reductions in plywood gross margin for both the industry and Great Western in 2018 and 2017. Great Western has traditionally had a somewhat lower gross margin for softwood than the industry until 2017, when the gross margin went up significantly due to aggressive selling. Audit Evidence - 48

Lesley had researched the industry and found that hardwood gross margin was stable and approximately 3. 5 – 4 percent lower than Great Western every year. Industry gross margin for plywood has declined annually but is about 10 percentage pint higher than Great Western’s. Industry gross margin for softwood has been stable for the three years, but Great Western’s has increased by a fairly large amount. REQUIRED a. Based upon the changes in gross margins, which product sales could be potentially misstated? What calculation helps to quantify the risk of material misstatement? b. Identify the potential causes of the change in gross margin. c. How would potential over- or understatements discussed in part (b) affect the audit process? d. Want additional steps or procedures should Lesley perform to corroborate what the controller has told her (aside from researching the industry)? Audit Evidence - 49