Unit Four: Audit responsibilities, Objectives,

Evidence and recording the audit

4.1: Objectives of conducting F/S audit
4.2: Managements’ responsibility
4.3: Auditor’s responsibility
4.4: Management assertions
4.5: General transactions related audit objectives
4.6: General balance related audit objectives
4.7: Relationship of management assertions and audit objectives
4.8: Phases of financial statement audit
4.9 Audit evidence
4.10 Audit documentation
 Objectives of conducting F/S audit

• The objective of an ordinary audit is “to express

an opinion as to the fairness with which the
financial statements present fairly, in all material
respects, the financial position, results of
operations, and cash flows, in conformity with
international financial reporting standard.”
• Thus the primary objective of F/S audit is to
express an opinion on the financial statements.
 Auditor’s Responsibilities
• The auditors are responsible to provide an
opinion as to the fairness of the F/S. These
responsibilities include
• planning and performing the audit and
• providing reasonable assurance that the
statements are free of material misstatement.
• The auditor may also be responsible for
reporting on internal control weaknesses
 Auditor’s Responsibilities
• The term “reasonable assurance” requires professional judgment.
• The auditing standard does not require 100% assurance, but clearly,
there must be some substantive evidence available in judging the
financial statements.
• Typically, the assurance is based on sampling information—which
introduces the possibility of risk that problems may exist, but not
within the sample measures.
• Additionally, the complexity of accounting measures may add a
layer of difficulty in making a clear judgment.
• And one must also consider the possibility that employees may be
hiding some data from the auditor. All of these cloud the issue of
what is reasonable assurance
 Auditor’s Responsibilities
For Going-Concern Assumption
• Auditor is required to evaluate client's ability to remain a
going concern for reasonable period of time from the balance
sheet date.
• Indicators of potential going concern problems include
 Negative trends in key financial areas like cash flow, sales,
profits
 Internal matters, such as loss of key personnel, and
 outdated facilities and/or products
 External matters, such as new legislation, loss of significant
customer or supplier,
 uninsured casualty loss
 Auditor’s Responsibilities
 Other matters, such as loan default, inability to pay
dividends, attempted debt restructuring
 Significant changes in the competitive market and the
competitiveness of the client’s products
• If there is substantial doubt about ability of client to
remain a going concern, auditor should
 Discuss the situation with management
 Assess management's plan to overcome problems
 Consider the effects on the financial statements
 Consider the effects on the audit report and issue
appropriate audit opinion
 Auditors responsibility for reviewing
contingencies
Contingent losses that are probable, reasonably
estimated, and remote should be accrued and
disclosed
Contingencies include:
• Threat of expropriation of assets in a foreign country
• Litigation, claims, and assessments
• Guarantees of debts of others
• Agreements to repurchase receivables that have been
sold
• Purchase and sale commitments
 Auditors responsibility for reviewing
contingencies
• Management is responsible for identifying,
evaluating, and accounting for contingencies
• Auditor is responsible for determining client
has properly identified, accounted for, and
disclosed material contingencies
• Sources of Evidence for contingencies include
management and client's legal counsel, corporate
minutes, contracts, correspondence from
government agencies, and bank confirmations
 Auditors responsibility for subsequent events

• Subsequent events are events coming into existence after the

balance sheet date and require special audit attention
• Types of Subsequent Events
Type 1 subsequent events
• Provide additional evidence about conditions that existed at the
balance sheet date.
• The financial statement numbers should be adjusted to reflect
this information.
• Examples of type 1 subsequent events:
 Major customer files for bankruptcy during subsequent period,
its deteriorating financial condition existed prior to the balance
sheet date
 Lawsuit settled for different amount than accrual
 Auditors responsibility for subsequent events
Type 2 subsequent events:
• provide evidence about conditions that did not exist at the
balance sheet date
• The financial statement should not be adjusted for these events,
but they should be considered for disclosure. Examples
• Uninsured casualty loss that occurs after the balance sheet date
• Significant lawsuit initiated for incident occurring after the
balance sheet date
• Significant loss due to natural disaster occurring after the
balance sheet date
• Major decisions made during the subsequent period such as to
merge, discontinue a line of business, or issue new securities
 Auditors responsibility for subsequent events
Audit procedures used to identify subsequent events include:
• Read minutes of meetings of the board of directors,
stockholders, and other authoritative groups held after year end
• Read interim financial statements; investigate significant
changes
• Inquire of management about:
 Significant changes noted in interim statements
 Significant contingent liabilities
 Significant changes in working capital, debt, or owners' equity
 Status of any tentative items
 Unusual accounting adjustments made after balance sheet date
 Auditors responsibility for subsequent events

• If subsequent event occurs after end of

fieldwork but before audit report is issued,
auditor shall use the date when he/she
completes his/her filed work to limit his/her
responsibilities.
• Recent developments in audit recommends
auditors to disclose all subsequent event
coming into existence till the date of issuing
the audit report.
 Auditors responsibility for Review of
Significant Estimates
• Management estimates provide opportunities for the
entity to "manage" or even manipulate earnings
• Companies may underestimate liabilities or
impairment of asset values to achieve reported
earning goals
• The auditor shall provide reasonable assurance that
 Management has information system to develop
estimates material to the financial statements
 Estimates are reasonable and
 Estimates are presented per IFRS
 Auditors responsibility for Review of
Significant Estimates
• In evaluating management estimates, the
auditor concentrates on key factors and
assumptions that are:
– Significant to the accounting estimate
– Sensitive to variations
– Deviations from historical patterns
– Susceptible to misstatement and bias
– Inconsistent with current economic trends
Auditors responsibility for Evaluating Adequacy
of Disclosures
Auditor must be sure that:
• Disclosed events and transactions occurred
and pertain to the entity
• All disclosures that should be included are
included
• Disclosures are understandable to users
• Disclosures are accurate
 Auditors” responsibility for Management
Representations
• Auditor shall seek Management Certification of
F/Statements
–Recent development in auditing is about
Sarbanes/Oxley Act that requires CEO and CFO
to certify financial statements are fairly
presented in accordance with GAAP/IFRS
– Auditor should review management‘ processes
for certification and seek written Management
Representation Letter
 Auditors” responsibility for Management
Representations
 Management Representation Letter:-
• Reminds management of its
responsibility for the financial statements
• Confirms significant oral responses
made by management
• Reduces possibility of misunderstandings
between management and auditor
 Auditors” responsibility for Management
Representations
• Management Representation Letter is often prepared by
auditor on client letter head, addressed to the auditor, and
normally signed by CEO and CFO
• Letter is dated as of the audit report date (end of
fieldwork)
• Because management representations are not strong
evidences, the auditor should perform procedures to
corroborate the information in the letter
• Management's failure to provide this letter is a scope
limitation sufficient to preclude issuance of unqualified
opinion
 Managements’ responsibility
• Management is primarily responsible for the
fairness of the financial statements, which is
logical, because management operates the
business. Auditors must base their conclusion
of fairness on the results of the audit.
• Thus management is primarily responsible for
the financial statements and for internal
control
 Management Assertions

Management Assertions are representations of

management that are set forth in the financial
statements. Broadly speaking a set of financial
statements contains the following five management
assertions:
 Assertions about existence or occurrence
 Assertions about completeness
 Assertions about valuation or allocation
 Assertions about rights and obligations
 Assertions about presentation and disclosure
 Management Assertions

 Existence or occurrence: Assets, liabilities, owners’ equity,

revenues and expenses reflected in the financial statements
exist and the recorded transactions have occurred.
 Completeness: All transactions, assets, liabilities, owners’
equity, revenues and expenses that should be presented in
the financial statements are included.
 Rights and Obligations: The client has rights to assets and
obligations to pay liabilities that are included in the
financial statements.
 Valuation or allocation: Assets, liabilities, and owners’
equity, revenues and expenses are presented at amounts that
are determined in accordance wit accounting principles
 Management Assertions

 Presentation and disclosure: Accounts are described and

classified in the financial statements in accordance with
international financial reporting standard and all material
disclosures are provided.
• The audit program for each financial statement account must be
tailored to accomplish the specific audit objectives for that account.
• The specific objectives for auditing cash are not identical to the
specific objectives for auditing inventory. Although the specific
audit objectives and therefore, the audit procedures differ for each
account, it is useful to realize that each audit program follows
basically the same approach to verifying the balance sheet items
and related income statement amounts.
 Transaction-Related Audit Objectives

 There are six general transaction-related objectives:

 Existence—recorded transactions exist;
 Completeness—existing transactions are recorded;
 Accuracy—recorded transactions are stated at the correct amounts
 Classification—transactions included in the client's journals are properly
classified;
 Timing/ cut off—transactions are recorded on the correct dates; it
addresses whether transactions are recorded in the proper accounting
period. Recording a sales transaction in December when the goods were
not shipped until January violates the cutoff assertion.
 Posting and summarization—recorded transactions are properly included
in the master files and are correctly summarized.
 Balance-Related Audit Objectives
There are 9 balance-related audit objectives:
 Existence—amounts included are exist
 Completeness—existing amounts are included
 Accuracy—amounts included are stated at correct amounts EX An
inventory item on a client’s inventory listing can be wrong because the
number of units of inventory on hand was misstated, the unit price was
wrong
 Classification—amounts included in the client's listing are properly
classified
 Cutoff—transactions near the balance sheet date are recorded in the proper
period
 Detail tie-in—details in the account balance agree with related master file
amounts, foot to the total in the account balance, and agree with the total in
the general ledger
 Realizable value—assets are included at the amounts estimated to be
realized
 Rights and obligations _ The entity holds or controls the rights to assets, and
liabilities are the obligations of the entity.
 Presentation and disclosure—account balances and related disclosure
 Major transaction cycles
 While auditing, auditors generally find it useful to subdivide
the overall audit engagement system into its major transaction
cycles.
 The term transaction cycle refers to the policies and the
sequence of procedures for processing a particular type of
transaction.
 Major transaction cycles include:
1. Sales and collection cycle
2. Acquisition and payment/purchasing cycle
3. Inventory and warehousing/ production
4. Capital acquisition and repayment
5. Payroll and personnel
 Major transaction cycles
• Sales and collection cycle: this cycle involves
procedures and policies for obtaining orders from
customers, approving credit, shipping merchandise,
preparing sales invoice, recording revenue and
accounts receivable, billing, handling and recording
cash receipts
• Purchase or acquisition and payment cycle: This
cycle includes procedures for initiating purchases of
inventory, other assets or services , placing purchase
orders, inspecting goods upon receipts and preparing
receiving reports, recording liabilities to vendors,
authorizing payments and making and recording cash
disbursements
 Major transaction cycles
• Production (inventory and warehousing) cycle): includes
procedures for storing materials, placing materials in to production,
assigning production costs to inventories and accounting for the
cost of goods sold
• Financing cycle (capital acquisition and repayment cycle): this
cycle includes procedures for authorizing, executing, and recording
transactions involving bank loans, leases, bonds and capital stock .
• Payroll and personnel cycle: Includes procedures for hiring,
firing, determining pay rates, timekeeping, computing gross
payroll, payroll taxes and amounts withheld from gross pay,
maintaining payroll records and preparing and distributing
paychecks.
 major transaction cycles
 In each of the transaction cycles, the auditor
shall be familiar with:-
 Business functions
Possible accounts that could be affected
 The internal control polices and procedures
designed to control transactions in each of the
business functions and transaction cycles
including tests of control and substantive
tests
 Major transaction cycles

Because sales transactions, receivables and cash receipts

are closely related, these accounts can be considered
jointly in a discussion of auditing objectives and
procedures.
 For instance sale sand collection cycle includes the
following business functions
• Receiving of orders from customers and credit approval
• Delivery of merchandise to the customer
• Billing of merchandise to the customer
• Recording of receivables
• Collection of receivables
• Write-off of receivables if any
 major transaction cycles

• From sales and collection cycle the following

accounts can be identified.
 Sales, Accounts receivable or Notes
receivable, cash, uncollectible accounts
expense and allowance for doubtful account.
The auditor undertaking audit of sales and
collection cycle should be quite familiar with
accounting recording of sales, collections and
write-offs.
 major transaction cycles
Designing tests of Control and Substantive test of Transactions
• Although specific audit procedures vary from one engagement to
the other, the fundamental steps which follow planning of the
audit process are essentially the same in every engagement.
These are:
1. Obtain an understanding of internal control sufficient to plan
the audit
2. Asses control risk and design test of controls
3. Perform additional test of controls
4. Reassess control risk and design substantive tests
5. Perform substantive tests and complete the audit
 Major transaction cycles
1. Obtain an understanding of internal control sufficient to plan the audit:

Understanding of internal control refers to the need to have knowledge and understanding of:
 How it works
 What procedures are performed and who performs them
 What controls are in effect
 How various types of transactions are processed and recorded
 What accounting records and supporting documentation exist
 Sequence of procedures used in processing major categories of transactions
 Proper authorization of transactions and activities
 Appropriate segregation of duties (fundamental concept of internal control)
 Adequate documentation and recording of transactions and events
 Proper valuation of recorded amounts
 Major transaction cycles
2. Asses control risk and design test of controls
• After analyzing the design of the internal control structure, the
auditors must decide whether the structure, as designed, seems
strong enough to prevent or to detect and correct material
misstatements.
• If they assess internal control to be week (control risk is high),
they will rely primarily on substantive tests to reduce audit risk
to an acceptable level.
• On the other hand, if the system seems capable of preventing
or detecting and correcting material misstatements, the auditor
muse decide which additional controls if any can efficiently be
tested?
 major transaction cycles
• Control Risk: is the risk that the client’s system of
internal control will not prevent or correct such
errors.
• To assess control risk, the auditor should consider
the adequacy of control design as well as test
adherence of the client employees to control
polices and procedure.
• The auditor’s major objective at this point is to
determine which internal controls if any merit
additional testing. This involves:
 Major transaction cycles
• Tests of controls are used by the auditors to obtain evidence
about whether the tested policy or procedure operates in a
manner that would prevent or detect material misstatement.
That is test of controls are used to evaluate the effectiveness
of both the design and operation of controls. Tests of controls
focus on compliance with procedures.
How to test controls? Controls may be tested by
• Inquiries of appropriate client personnel
• Inspection of documents and reports
• Observation of the application of accounting policies or
procedures
• Re-performance of the application of the policy or procedures
by the auditors
 Major transaction cycles
 After completing their tests of controls, the auditors are in
a position to reassess control risk based on the results of
the test and determine the nature, timing and extent of the
substantive tests necessary to complete the audit of sales
and receivables.
 Substantive tests/procedures are tests designed to obtain
evidence as to the completeness, accuracy and validity of
the data produced by accounting system. They are of two
types:
(1)Tests of details of transactions and balances.
(2)Analysis of significant ratios and trends including the
resulting investigation of unusual fluctuations and items.
 Phases of Financial Statement Audit

In general for all transaction cycles, there are seven phases to
be passed by auditor while auditing financial statements: These
are:
1. Audit planning: Involves
 This is developing an overall strategy for performing the audit, including audit
program
 Establishing an understanding with their clients as to the nature of services to
be provided and responsibilities of each party (Engagement letter)
2. Obtain an understanding of the client and its environment
including internal control
3. Assess Risks of misstatement and design further audit
procedures
4. Perform tests of control
5. Perform substantive tests of procedures
6. Complete the audit’
7. Issue an audit report
 The objective of audit documentation

• Audit documentation is the record of audit

procedures performed, relevant audit evidence
obtained, and
• conclusions the auditor reached (terms such as
'working papers' or 'work papers' are also sometimes
used).
• All audit work must be documented: the working
papers are the tangible evidence of the work done in
support of the audit opinion. ISA 230 Audit
documentation states that the auditor shall prepare
audit documentation on a timely basis.
 Audit documentation
 Audit documentation is necessary for the following reasons:
A. It provides evidence of the auditor's basis for a conclusion
about the achievement of the overall objective.
B. It provides evidence that the audit was planned and performed
in accordance with ISAs and other legal and regulatory
requirements.
C. It assists the engagement team to plan and perform the audit.
D. It assists team members responsible for supervision to direct,
supervise and review audit work.
E. It enables the team to be accountable for its work.
F. It allows a record of matters of continuing significance to be
retained.
G. It enables the conduct of quality control reviews and
inspections (both internal and external)
 Audit Evidence
Written evidence is preferable to oral evidence;
independent evidence obtained from outside the
organization is more reliable than that obtained
internally; and evidence generated by the auditors
is more reliable than that obtained from others.
 Audit Evidence and Audit Documentation
Concepts of Audit Evidence
• Audit evidence is all the information used by the auditor
in arriving at the conclusions on which the audit opinion
is based.
• A solid understanding of the characteristics of evidence is
obviously an important conceptual tool for auditors
The following concepts of audit evidence are important to
understanding the conduct of the audit:
a) The nature of audit evidence.
b) The sufficiency and appropriateness of audit evidence.
c) The evaluation of audit evidence.
a) The Nature of Audit Evidence
• Audit evidence is the information auditors obtain in
arriving at the conclusion on which their report is based.
• Audit Evidence is the information gathered or used by the
auditor to support his or her opinion.
• Audit evidence comprises source documents and
accounting records underlying(original) the financial
statement assertions and corroborative evidence from
other sources.
• The auditor gathers evidence by performing audit
procedures.
• These audit procedures consists of test of controls and
substantive procedures.
i. Test of Controls:
• are audit procedures to test the effectiveness of control
policies and procedures to prevent or detect material
misstatement.
• Depending on the results of this test, auditors may choose
to rely up a client’s control system as part of their
auditing activities.
• The extent to which the test of controls are applied
depends on the assessed control risk.
ii. Substantive tests:
• are audit procedures designed to test for dollar
misstatements directly affecting the correctness of
• Such misstatements are clear indicators of the
misstatements of the accounts.
• These tests are needed as evidence to support the
assertion that the financial records of an entity are
complete, valid and accurate.
There are three types of substantive tests:

1. Substantive tests of transactions: evaluating the client’s

recording of transactions by verifying the monetary
amounts.
2. Analytical procedures: involves comparison of recorded
amounts to expectations developed by the auditor.
• They often involve the calculation of ratios by the auditor
for comparison with previous years’ ratios and other
• The nature of the evidence refers to the form or type of
information, which include accounting records and other
available information.
1. Accounting records include the records of initial entries
and supporting records, such as checks and records of
electronic fund transfers; invoices; contracts; the general
and subsidiary ledgers, journal entries, and other
adjustments to the financial statements that are not
reflected in formal journal entries; and records such as
worksheets and spreadsheets (tables) supporting cost
allocations, computations, reconciliations, and
disclosures.
• Many times the entries in the accounting records are
initiated, recorded, processed, and reported in electronic
2. Other information that the auditor may use as audit
evidence includes minutes of meetings; confirmations
from third parties; industry analysts’ reports; comparable
data about competitors (benchmarking); control manuals;
information obtained by the auditor from audit procedures
such as inquiry, observation, and inspection; and other
information developed by, or available to, the auditor that
permits the auditor to reach conclusions through valid
reasoning.
• For some entities, accounting records and other
information may be available only in electronic form.
• Therefore, source documents such as purchase orders, bills
of lading, invoices, and checks are replaced with electronic
messages or electronic images.
• Two common examples are electronic data interchange
(EDI) and image processing systems.
1. A client that uses EDI may process sales or purchase
transactions electronically.
• For example, the client’s EDI system can contact a vendor
electronically when supplies of a part run low.
• The vendor will then ship the goods to the client and send
an invoice electronically.
• The client can authorize its bank to make an electronic
payment directly to the vendor’s bank account.
2. In an image processing system, documents are scanned
and converted to electronic images to facilitate storage and
reference, and the source documents may not be retained
after conversion.
• In such systems, electronic evidence may exist at only a
certain point in time and may not be retrievable later. This
may require the auditor to select sample items several
times during the year rather than at year-end.
b) The Sufficiency and Appropriateness of Audit
Evidence
• Auditors should obtain sufficient appropriate audit
evidence to draw reasonable conclusions on which to base
the audit opinion.
 Sufficiency is the measure of the quantity of audit
evidence.
 Appropriateness is a measure of the quality of audit
evidence.
• The quantity of audit evidence needed is affected by the
risk of misstatement and by the quality of the audit
evidence gathered.
 Thus, the greater the risk of misstatement, the more
audit evidence is likely to be required to meet the audit
test.
 And the higher the quality of the evidence, the less
evidence that may be required to meet the audit test.
• Accordingly, there is an inverse relationship between the
sufficiency and appropriateness of audit evidence.
• In most instances, the auditor relies on evidence that is
persuasive rather than convincing in forming an opinion
on a set of financial statements.
This occurs for two reasons.
• First, because an audit must be completed in a reasonable
amount of time and at a reasonable cost, the auditor
examines only a sample of the transactions that compose
the account balance or class of transactions.
• Thus, the auditor reaches a conclusion about the account
or class based on a subset of the available evidence.
• Second, due to the nature of evidence, auditors must
often rely on evidence that is not perfectly reliable.
• As discussed in the next section, the types of audit
evidence have different degrees of reliability, and even
highly reliable evidence has weaknesses.
• For example, an auditor can physically examine inventory,
but such evidence will not ensure that obsolescence is not
a problem.
• Therefore, the nature of the evidence obtained by the
auditor rarely provides absolute assurance about an
assertion.
 Evidence is considered appropriate when it provides
information that is both relevant and reliable.
Relevance: The relevance of audit evidence refers to its
relationship to the assertion or to the objective of the
control being tested.
• If the auditor relies on evidence that is unrelated to the
assertion, he or she may reach an incorrect conclusion
• A normal audit procedure for testing this assertion is to
trace a sample of shipping documents (such as bills of
lading) to the related sales invoices and entries in the
sales journal.
• If the auditor samples the population of sales invoices
issued during the period, the evidence would not relate to
the completeness assertion (that is, the auditor would not
detect shipments made that are not billed or recorded).
• The auditor should check the log (record) of pre-numbered
bills of lading, after ascertaining that such documents
were issued for all customer shipments.
• Any conclusion based on the population of sales invoices
would not be based on evidence relevant to testing the
completeness assertion.
Reliability: The reliability or validity of evidence refers to
whether a particular type of evidence can be relied upon
to signal the true state of an assertion.
• Because of varied circumstances on audit engagements, it
is difficult to generalize about the reliability of various
types of evidence.
However, the reliability of evidence is influenced by;
1. The source from where the evidence is obtained i.e.
whether external or internal
2. The effectiveness of the internal control system of the
client company
3. The collection procedure of the evidence i.e. whether
obtained directly or indirectly
4. The types of evidence i.e. whether they are documents or
1. Knowledgeable independent source of the evidence:

• Evidence obtained directly by the auditor from a

knowledgeable independent source outside the entity is
usually viewed as more reliable than evidence obtained
solely from within the entity.
• Thus, a confirmation of the client’s bank balance received
directly by the auditor would be viewed as more reliable
than examination of the cash receipts journal and cash
balance as recorded in the general ledger.
2. Effectiveness of internal control.

• When the auditor assesses the client’s internal control as

effective (that is, low control risk), evidence generated by
that accounting system is viewed as reliable.
• Conversely, if internal control is assessed as ineffective
(that is, high control risk), the evidence from the
accounting system would not be considered reliable.
• Thus, the more effective the client’s internal control, the
more assurance it provides about the reliability of audit
evidence.
3. Auditor’s direct personal knowledge:

• Evidence obtained directly by the auditor (e.g.,

observation of the performance of a control) is generally
considered to be more reliable than evidence obtained
indirectly or by inference (e.g., inquiry about the
performance of a control).
• For example, an auditor’s physical inspection of a client’s
inventory is considered to be relatively reliable because
the auditor has direct personal knowledge regarding the
inventory.
• In some cases, the auditor may need the skill and
knowledge of a specialist to assist with the inventory
4. Documentary evidence.

• Audit evidence is more reliable when it exists in

documentary form, whether paper, electronic, or other
medium.
• Thus, a written record of a board of directors meeting is
more reliable than a subsequent oral representation of the
matters discussed.
 Original documents. Audit evidence provided by original
documents is more reliable than audit evidence provided
by photocopies or facsimiles (true copy).
 Auditor should consider whether the document is of a type
that could easily be forged or created in its entirety by a
dishonest employee.
The documentary evidence is classified into three
categories;
1) Documents created outside the org. and transmitted
directly to the auditor: The most reliable documentary
evidence consists of documents created by independent
parties outside the organization and transmitted directly
to the auditors without passing through the client’s hands.
E.g. the verification of accounts receivable
2) Documents created outside the organization and
held by the organization: Externally created documents
referred by the auditors will be in the ownership of
organization.
E.g. bank statements, vendor’s invoices, property tax
3) Documents created and held within the
organization:

Most documents created and held within the

organization represent a lower quality of evidence
because they circulate only within the company and do
not receive critical review by an outsider.
E.g., the sales invoices, shipping notices, purchase
orders etc.

 The degree of reliance to be placed on this documents

depends on the effectiveness of the internal control.
 if all documents are serially numbered and all
numbers in the series accounted for, these documents
c) The Evaluation of Audit Evidence
• The ability to evaluate evidence appropriately is another
important skill an auditor must develop.
• Proper evaluation of evidence requires that;
 the auditor understand the types of evidence that are
available and their relative reliability.
• The auditor must be capable of assessing,
 when a sufficient amount of appropriate evidence has
been obtained in order to determine the fairness of
management’s assertions.
• In evaluating evidence, an auditor should be thorough in
searching for evidence and unbiased in its evaluation.
Relationships of audit evidence to audit report
• Auditing standards provide the basic framework for the
auditors understanding of audit evidence and its use in
supporting his or her opinion on the financial statements.
• The auditor gathers evidence by conducting audit
procedures to test management assertions.
This evidence serves as the support for the auditor’s opinion
about whether various financial statements components
are fairly presented, which reflect management’s
assertions about them.
• The auditor tests management’s assertions by conducting
audit procedures on whether each relevant management
assertion is supported by evidences.
Figure 4-1: An Overview of the Relationships among the
Financial Statements, Management Assertions, Audit
Procedures, and the Audit Report

Audit report

Auditor reaches
Financial
statements a conclusion based
on the evidence

Management
assertions
Provide evidence on
about components
the fairness of the
of financial statements
financial
statements

Audit
procedures
Types of Audit Evidences and Audit Procedures

• By conducting audit procedures, the auditor examines

various types of audit evidence. Evidence is commonly
categorized into the ff types:
a) Inspection of Records or Documents: Inspection
consists of examining internal or external records or
documents that are in paper form, electronic form, or other
media.
• On most audit engagements, inspection of records or
documents makes up the bulk of the evidence gathered by
the auditor.
• Examples of audit evidence through inspection of records
or documents:
 Examining corporate minutes to determine the
  Comparing a duplicate sales invoice with the sales
journal for customer name and amount.
 Examining an insurance policy stating the amount of
the fire insurance coverage on buildings and
equipment.
Two issues are important in discussing inspection of records
or documents: the reliability of such evidence and its
relationship to specific assertions.
1. Reliability of Records or Documents: A previous
section noted the independence of the source of evidence
as a factor that affected the reliability of audit evidence.
• In particular, evidence obtained from a knowledgeable
source outside the entity is generally considered more
Typically a distinction is made between internal and external
documents.
a) Internal documents are generated and maintained
within the entity; that is, these documents have not been
seen by any party outside the client’s organization.
Examples include duplicate copies of sales invoices and
shipping documents, materials requisition forms, and work
sheets for overhead cost allocation.
b) External documents are of two forms: documents
originating within the entity but circulated to independent
sources outside the entity and documents generated
outside the entity but included in the client’s accounting
records. Examples of the first include remittance advices
returned with cash receipts from customers and payroll
checks, while examples of the second include bank
2. Documentary Evidence Related to Assertions: The second
issue concerning records or documents relates directly to the
occurrence and completeness assertions and to the direction
of testing taken when documentary evidence is examined.
• The direction of testing between the accounting records and
source documents (such as: sales invoices or shipping
documents) is important when testing the occurrence and
completeness assertions.
 Vouching refers to selecting an item for testing from the
accounting journals or ledgers and then examining the
underlying source document. Therefore, the direction of
testing is from the journals or ledgers back to the source
documents. This approach provides evidence that items
included in the accounting records have occurred (occurance)
or are valid transactions.
 Tracing refers to first selecting a source document and
then following it into the journal or ledger. The direction
of testing in this case is from the source documents to the
journals or ledgers.
• Testing in this direction ensures that transactions that
occurred are recorded (completeness) in the accounting
records.

Figure 3.3: Direction of Testing for Validity and Completeness.

b) Inspection of Assets
• Inspection of tangible assets consists of physical
examination of the assets.
• Inspection is a relatively reliable type of evidence that
involves the auditor inspecting or counting a tangible
asset.
• An audit engagement includes many situations in which the
auditor physically examines an entity’s assets. Examples;
counting cash on hand, examining inventory or marketable
securities, and examining tangible fixed assets.
• This type of evidence primarily provides assurance that the
asset exists.
• Physical examination (inventory) may also provide evidence
on valuation by identifying items that are obsolete or slow-
• However, physical examination provides little or no
assurance for the rights and obligations assertion.
• Examples of audit evidence through Inspection (physical
examination):
 Make a petty cash count to make sure that the amount
of the petty fund is intact.
 Examine a piece of equipment to make sure that a
major acquisition was actually received and is in
operation.
 Count inventory items and record the amount in the
audit files.
C) Observation
• Observation consists of looking at a process or procedure
being performed by others. The actions being observed
typically do not leave an audit trail that can be tested by
examining records or documents. Examples of
observation:
 Watch employees count inventory to determine whether
company procedures are being followed.
 Stand by the payroll time clock to determine whether
any employee "punches in" more than one time.
• Observation provides audit evidence about the
performance of a process or procedure but is limited to the
point in time at which the observation takes place.
• It is also limited by the fact that the client personnel may
act differently when the auditor is not observing them.
• Observation is useful in helping auditors understand client
processes, but is generally not considered very reliable and
thus generally requires additional corroborating evidence
by the auditor.
D) Inquiry
• Inquiry consists of seeking information of knowledgeable
persons (both financial and nonfinancial) throughout the
entity or outside the entity.
• Inquiry is an important audit procedure that is used
extensively throughout the audit and often is
complementary (additive) to performing other audit
• For example, much of the audit work conducted to
understand the entity and its environment including
internal control involves inquiry.
Examples of audit evidence gathered through inquiry:
 Obtaining information about internal control by
requesting the client to fill out a questionnaire.
 Obtaining a letter from management stating that there
are no unrecorded liabilities.
 Reviewing the accounts receivable with the credit
manager to evaluate their collectability.
• Inquiries may range from formal written inquiries to
informal oral inquiries.
• Evaluating responses to inquiries is an integral part of the
inquiry process.
• The reliability of audit evidence obtained from responses
to inquiries is also affected by the training, knowledge,
and experience of the auditor performing the inquiry,
 because the auditor analyzes and assesses responses
while performing the inquiry and refines subsequent
inquiries according to the circumstances.
• In some cases, the nature of the response may be so
significant that the auditor requests a written
representation from the source.
• Inquiry alone ordinarily does not provide sufficient audit
evidence, and the auditor will gather additional
corroborative evidence to support the response.
Techniques for Conducting and Evaluating Inquiries

In conducting inquiry, the auditor should;

• Consider the knowledge, objectivity, experience,

responsibility, and qualifications of the individual to be
questioned.
• Ask clear, concise, and relevant questions.
• Use open or closed questions appropriately.
• Listen actively and effectively.
• Consider the reactions and responses and ask follow-up
questions.
• Evaluate the response.
E) Confirmation
 Confirmation is the process of obtaining a demonstration
of information or of an existing condition directly from a
third party.
 Confirmations are also used to obtain audit evidence
about the absence of certain conditions, for example, the
absence of a “side agreement” that may influence revenue
recognition.
• Auditors usually use the term inquiry to refer to unwritten
questions asked of a third party, and the term
confirmation to refer to written requests for a written
response from a third party.
• The reliability of evidence obtained through confirmations
is directly affected by factors such as
 The form of the confirmation (Positive or Negative).
  The nature of the information being confirmed.
 The intended respondent.
• Confirmations are used extensively on audits; they
generally provide reliable evidence for the existence
assertion and, in testing certain financial statement
components (such as accounts payable), can provide
evidence about the completeness assertion.
• Evidence about other assertions can also be obtained
through the use of confirmations.
For example, an auditor can send a confirmation to a
consignee to verify that a client’s inventory has been
consigned.
• The returned confirmation provides evidence that the
The following are additional examples of confirmation
which can be done by auditor:
 Obtaining a letter from the client's attorney addressed
to the CPA firm stating that the attorney is not aware
of any existing lawsuits.
 Obtaining a written statement from a bank stating that
the client has $15,671 on deposit and liabilities of
$500,000 on a demand note.
 Obtaining a letter from an insurance company to the
CPA firm standing the amount of the fire insurance
coverage on buildings and equipment.
Table 3-1. Amounts and Information Frequently Confirmed by
Auditors INFORMATION SOURCE
Assets
Cash in bank Bank
Cash surrender value of life insurance Insurance company
Accounts receivable Customers
Notes Receivable Maker
Owned inventory on Consignment Consignee
Inventory held in public warehouse Warehouse
Liabilities
Accounts Payable Creditor
Notes Payable Lender
Advance from Customers Customer
Mortgage Payables Mortgager
Bonds Payable Bondholder
Owner’s equity
Shares Outstanding Register and transfer agent
Other information
Insurance Coverage Insurance company
Contingent Liabilities Bank, Lender and Client's legal
Bond Issuance agreements counsel
Collateral held by Creditors Bondholder
Creditor
F) Re-calculation
• Recalculation consists of checking the mathematical
accuracy of documents or records.
• Recalculation can be performed through the use of
information technology (e.g., by obtaining an electronic
file from the entity and using computer assisted audit
techniques (CAATs), to check the accuracy of the
summarization of the file).
• Specific examples of this type of procedure include:
 Extend the cost of inventory times the quantity on an
inventory listing to test whether it is accurate.
 Add the sales journal entries to determine whether
they were correctly totaled.
 Recalculate the depreciation expense on fixed assets
and recalculation of accrued interest.
G) Re-performance

• Re-performance involves the independent execution by

the auditor of procedures or controls that were originally
performed by company personnel.
• For example, the auditor may re-perform the aging of
accounts receivable, trace the total cash disbursements
journal to the general ledger.
• Again, because the auditor creates this type of evidence,
it is normally viewed as highly reliable.
H) Analytical Procedures

• Analytical procedures involve evaluations of the financial

statements by a study of relationships among financial and
non-financial data.
For example, the current-year accounts receivable balance
can be compared to the prior-years’ balances after
adjusting for any increase or decrease in sales and other
economic factors.
• The auditor makes such comparisons either to identify
accounts that may contain material misstatements and
require more investigation or as a reasonableness test of
the account balance.
 1. Develop an expectation of an account balance
2. Determine the amount of difference from the
expectation that can be accepted without investigation
(tolerance level)
3. Compare the account balances with the expected
account balance
4. Investigate the significant deviations from the expected
account balance
• Analytical procedures are an effective and efficient form of
evidence.
• The reliability of analytical procedures is a function of
1) the availability and reliability of the data used in the
calculations,
2) the plausibility and predictability of the relationship
being tested,
I) Scanning
• Scanning is the review of accounting data to identify
significant or unusual items.
• This includes the identification of anomalous individual
items within account balances or other client data or
analysis of entries in transaction listings, subsidiary
ledgers, general ledger control accounts, adjusting
entries, suspense accounts, reconciliations, and other
detailed reports through the scanning .
• Scanning includes searching for large and unusual items
in the accounting records as well as reviewing transaction
data for indications of errors that have occurred.
• Scanning can be performed either manually or through
the use of computer assisted audit techniques (CAATs).
Reliability of the types of audit evidence
• Inspection of tangible assets, re-performance, and
recalculation are generally considered of high reliability
because the auditor has direct knowledge about them.
• Inspection of records and documents, scanning,
confirmation, and analytical procedures are generally
considered to be of medium reliability.
 The reliability of inspection of records and documents
depends primarily on whether a document is internal or
external, and the reliability of confirmation is affected
by the four factors listed previously.
 The reliability of analytical procedures may be affected
by the availability and reliability of the data.
• Finally, observation and inquiry are generally low-
reliability types of evidence because both require further
justification by the auditor.

Table 4–6 presents a hierarchy of the reliability of the types

General Reliability Relationship Type of Evidence
ofHigh
evidence.
er (a) Inspection of tangible
assets,
re-performance,
recalculation

(b) Inspection of records and

documents,
Medium confirmation, analytical
procedures,
scanning

Lower (c) Observation, inquiry

I. Evidence about Accounting Estimates
• The auditors must be especially careful in considering
financial statement accounts that are affected by estimates
made by management (often referred to accounting
estimates) particularly those for which a wide range of
accounting methods are considered acceptable.
Examples of accounting estimates include allowances for
loan losses and obsolete inventory, and estimates of
warranty liabilities.
• Making accounting estimates is management's
responsibility, and such estimates are generally more
susceptible to material misstatement than financial
statement amounts, which are more certain in amount.
 that:
a) all necessary estimates have been developed
b) the accounting estimates are reasonable, and
c) The accounting estimates are properly accounted for
and disclosed.
• When evaluating the reasonableness of accounting
estimates, the auditors may use one or more of the
following three basic approaches:
1) Reviewing and testing management's process of developing
the estimates:- this will involve evaluating the
reasonableness of the steps performed by management.
2) Independently developing an estimate of the amount to
compare to management's estimate.
3) Reviewing subsequent events or transactions bearing on
the estimate, such as actual payments of an estimated
• Related parties refer to the client entity and any other
party with which the client may deal where one party has
the ability to influence the other to the extent that one
party to the transaction may not pursue (follow) its own
separate interests.
Examples of related parties are officers, directors, principal
owners, members of immediate families, affiliated,
subsidiary companies, etc.
• A related party transaction is a transaction between the
company and these parties. The primary concern for the
auditor is that to check material related party transactions
are adequately disclosed in the client’s financial statement
or the related notes.
• Disclosure of related party transactions should include the
nature of the relationship, the description of the
Audit Documentation
• Audit standards require auditors to document relevant
information to support the conclusions and engagement
results.
 Audit documentation is the principal record of auditing
procedures applied, evidence obtained, and conclusions
reached by the auditor.
 The working papers are the tangible evidence of the work
done in support of the audit opinion.
 Working papers are the material the auditors prepare or
obtain, and maintain in connection with the performance of
the audit.
 Audit working papers should be safeguarded at all times
against the possibility of their being examined by
Working papers are a record of,
 the planning and performance of the audit
 the supervision and review of the audit work; and
 The audit evidence resulting from the audit work
performed which the auditors consider necessary and
support their report.

Working Papers include the following.

→ information on legal and organizational structure of the
client
→ copies of important legal documents, agreements and minutes
→ evidence of the planning process and any changes thereto
→ evidence on auditors' understanding of the accounting and
I.C. System
→ details of confirmation procedures on work carried out by other
auditors
→ copies of communications with other auditors, experts and
third parties
→ copies of letters with the client, reports to directors or
management and notes of discussions of entity's directors or
management concerning audit matters
→ letters of representation from the entity's directors or
management
→ a summary of the significant aspects of the audit including
details of the information available, the amount involved,
management's views, the conclusions reached and how these
matters are resolved or treated
→ Copies of the approved financial statements and auditor's
End of Chapter Four

Thank You!!!