Chapter 6 Audit Evidence

A. CHAPTER OUTLINE

I. Sunbeam Corporation II. Audit Evidence and Assertions A. Audit Evidence Defined B. Assertions and Specific Audit Objectives 1. Transaction Class Audit Objectives 2. Account Balance Audit Objectives 3. Disclosure Audit Objectives 4. A Few Examples III. Sufficiency of Audit Evidence A. Materiality B. Risk of Material Misstatement C. Size and Characteristics of the Population IV. Competency of Evidence A. Relevance of Audit Evidence B. Other Factors Related to the Reliability of Audit Evidence C. Professional Judgment V. Audit Procedures A. Inspection of Documents or Records 1. Vouching

2. Tracing B. Inspection of Tangible Assets C. Observation D. Inquiry E. Confirmation F. Recalculation G. Reperformance H. Analytical Procedures I. Computer-Assisted Audit Techniques VI. Four Decisions about Audit Procedures A. Staffing and Supervising the Audit B. Nature of the Audit Procedures C. Timing of the Audit Procedures D. Extent of the Audit Procedures VII. Documenting Audit Decisions and Audit Evidence A. Audit Programs B. Working Papers 1. Working Trial Balance 2. Schedules and Analyses 3. Audit Memoranda and Corroborating Information 4. Adjusting and Reclassifying Entries C. Preparing Working Papers 1. Reviewing Working Papers D. Working Paper Files E. Ownership and Custody of Working Papers VIII.Focus on Auditor Knowledge and Audit Decisions

B. CHAPTER HIGHLIGHTS 1. Audit evidence is defined as information used by the auditor in arriving at the conclusion on which the audit opinion is based. It includes client accounting records and other corroborating information. 2. Audit objectives for auditing transaction classes such as the credit sales cycle, cash receipts cycle, and sales adjustment cycle include: a. Occurrence recorded transactions are valid b. Completeness all transactions are recorded c. Accuracy all transactions are recorded accurately d. Cutoff all transactions are recorded in the proper time period e. Classification all transactions are recorded in the proper accounts 3. When auditing at the account balance level, such as accounts receivable, the audit objectives would be: a. Existence accounts receivable are valid b. Completeness all accounts receivable have been recorded c. Rights and obligations accounts receivable represent legal claims of the client d. Valuation and allocation accounts receivable are properly recorded at net realizable value 4. Specific audit objectives relating to disclosure for a cycle such as the revenue cycle are (a) occurrence and rights and obligations, completeness, understandability, and accuracy and valuation. 5. The third standard of fieldwork requires the auditor to obtain sufficient competent evidence through audit procedures to afford a reasonable basis for an opinion on the financial statements. 6. Sufficiency is affected by (a) materiality, (b) risk of material misstatement, and (c) size and characteristics of the population. 7. More evidence is generally needed for audit areas considered more material to the financial statements. More persuasive evidence is needed for areas that have a high risk of material misstatement, and, generally, the larger the population of transactions and the less homogeneous the population, the more evidence needed. 8. Competency is the measure of the quality or reliability of the audit evidence. Relevant evidence is evidence that is pertinent to the assertion being tested. For example, observing inventory is relevant for testing the existence assertion, but does not provide evidence about whether it is owned (rights or obligations assertion) by the client. Also, testing bank reconciliations at March 31st may provide reliable audit evidence, but it is not necessarily relevant for testing the clients December 31st cash balance.

9. The following factors affect the reliability of audit evidence: a. Independence of the source-outside sources, such as banks and customers are generally more reliable than inside (client) sources. b. Information obtained directly by the auditor is generally more reliable. c. Effective internal controls generally create more reliable evidence. d. Written evidence is generally more reliable then oral. e. Original documents are more reliable than photocopies or faxes. f. Consistent evidence from multiple sources increases evidence reliability. 10. The audit procedures that may be used to gather and evaluate audit evidence are: a. Inspecting documents and records, including vouching and tracing. b. Inspecting tangible assets. c. Observing or watching the performance of some activity. d. Inquiry of management and key employees either orally or in writing. e. Confirmation of information directly from independent sources outside the entity. i. Recalculation of calculations and reconciliations. g. Reperformance of procedures or controls. h. Analyzing ratios and other comparative data (i.e., analytical procedures). i. Computer-assisted audit techniques. 11. The procedure of tracing (i.e., trace daily sales journal totals to general ledger to see if they are posted) is useful in detecting the understatement of an account balance (completeness assertion). The procedure of vouching (e.g., select a sample of daily sales and vouch to detailed invoices to see if the sales really happened) is useful in detecting the overstatement of an account balance (existence or occurrence assertion). 12. In responding to assessed risk of material misstatements, the auditor makes decisions about (a) staffing and supervision, (b) nature of audit tests, (c) timing of audit tests, and (d) extent of audit tests. 13. Staffing and supervision involves assigning more experienced staff with higher industry experience and applying increased supervision to areas with more risk and less experienced staff to areas with less risk. 14. The nature of tests refers to the type and reliability of the evidence chosen. Cost/ benefit tradeoffs enter into the decision. For example, details testing may be more effective, but also more costly than performing analytical procedures. 15. The timing of tests deals with the decision on whether to test a given item at year-end or whether it is feasible to perform substantive testing at an interim date and, perhaps, do analytical procedures or other less costly procedures to update the balance to year end. The decision to test an account early is affected by inherent and control risk concerns. 16. The extent of tests relates to how much evidence to obtain and depends on other risk factors. Sample sizes are a matter of professional judgment which may

be aided by statistical methods or computer assisted audit techniques. 17. An audit program documents the audit procedures the auditor deems necessary to form an opinion about the fairness of the financial statements. Forms may vary, but the audit program should adequately outline the prescribed procedures and provide cross-referencing to the working papers where the procedures are documented. 18. Working papers may be defined as the records kept by the independent auditor of the procedures followed, the tests performed, the information obtained, and the conclusions reached pertinent to the audit. They provide support for the auditors report, a means for coordinating and supervising the audit, and evidence that the audit was made in accordance with GAAS. Documentation would normally include: a. Overall responses to risk of material misstatement b. The nature timing and extent of audit procedures performed c. Linkage of procedures to assessed risks d. Results of audit procedures e. Nature and effect of noted misstatements f. Conclusions about whether the noted misstatements are material, including qualitative considerations 19. Working papers are classified into the following types: (a) working trial balance, (b) schedules and analyses, (c) audit memoranda and corroborating information, and (d) adjusting and reclassifying entries. 20. A group schedule or lead schedule is one that summarizes the work on several accounts combined for reporting purposes (e.g., plant assets). A supporting schedule shows the work on one part of this grouping (e.g., the equipment accounts included in plant assets). Logical cross referencing helps organize the workpapers. For example, the lead schedule may be labeled A-1 indicating it is the 1st schedule in section A, while the supporting schedules may be referenced as A-1a, A1b, etc., indicating that they are supporting schedules to working paper A-1. 21. If a workpaper is originally prepared by client personnel and given to the auditor, an indication such as PBC or Aprepared by client@ is normally noted at the top of the workpaper. The use of A tick-marks@ is the technique used to indicate the auditing procedures performed. For example, if an auditor traces a client balance to a journal or ledger, a tic-mark such as # is placed by the client number and a corresponding # - traced to general ledger-amount agrees, is shown at the bottom of the workpaper. Some standardization of tic-marks is normal. For example, F usually refers to footing (adding a series of numbers). 22. Audit memoranda and corroborating information refer to written data prepared by the auditor in narrative form. Examples include extracts of the clients minutes of the Board of Directors meetings, and copies of important documents, such as lease or loan agreements. 23. Techniques of preparing workpapers include:

a. Heading- includes the client name, the workpaper title, and the date (clients year end) b. Index number- for cross referencing purposes c. Cross referencing to data taken from other workpapers d. Tick marks- symbols, such as check marks, used to indicate the audit procedure performed e. Signatures (of preparer and reviewers) and dates (date work performed) 24. There are several levels of review of working papers within a CPA firm. The first level review is made by the preparers supervisor to evaluate the scope of work performed, evidence and findings obtained, the judgment exercised, and the conclusions reached. Other reviews are made by the firms management team when field work has been completed. 25. One major category of working papers is the permanent file. This file contains data that are expected to be useful to the auditor on many future engagements with the client. Examples are copies of major lease agreements or depreciation schedules that are updated yearly. 26. A second major category of working papers is the current file. This file contains corroborating information pertaining to the execution of the current years audit only. Examples are current year accounts receivable confirmations or this years letter of representations from client management. 27. Working papers belong to the auditor and he or she is responsible for their safekeeping. The auditor should not disclose any confidential information in the workpapers without client consent. The Sarbanes-Oxley Act requires the auditor to retain workpapers for at least seven years.