CHAPTER THREE

AUDIT EVIDENCES DECISION

3.1 INTRODUCTION
Audit evidences gathered should be relevant, reliable and sufficient enough. Relevant evidence is
gathered through financial statement assertions.
Evidence refer to such data as purchase requisitions, purchase orders, vendor’s invoices,
receiving reports, paid checks, sales orders, sales invoices and soon. Evidence may be in
existence at the time an audit is started. It may be created during the course of an audit or it may
be the result of logical deduction.
The examination of evidence, transactions and original records involves detailed work which
must be performed prior to the examination of original records and underling evidences. The
system of internal control must be evaluated and an internal questionnaire should be prepared.
Then an audit program for the examination of original records and underlying evidences should
be developed.
Audit evidence can be obtained from various sources but the important factor is that whether the
source of the evidence must be sufficient relevant and reliable so that the auditor can fulfill his
satisfactory duty and form an opinion
Audit evidence includes all things that influence the auditor’s judgment regarding the conformity
of a Client’s financial presentations to GAAP. Most of the auditor’s work involves obtaining and
evaluating evidence.
3.2 EVIDENCE RELATED TO FINANCIAL STATEMENT ASSERTIONS
The conformity of a client’s financial statements to GAAP is judged according to five different
financial statement assertions.
1. existence or occurrence 4. valuation or allocation
2. completeness 5. presentation and disclosure
3. right and obligations
All evidence which is accumulated and then evaluated should be related to one or more of these
assertions. The evidence types and the evidence gathering techniques related to the assertions
will be examined.
1. Existence or Occurrence
Existence relates to balance sheet accounts. Did the assets, liabilities and equity which appear on
the balance sheet actually exist on the balance sheet date? Example, do all fixed assets listed on
the balance sheet actually exist?
1. Occurrence: - on the other hand refers to income statement accounts did the transactions
giving rise to the revenues and expenses actually occur during the period conversed by the
income statement?
Another way of expressing this assertion is to say “none of the accounts on the balance sheet or
income statement are overstated”. If accounts are overstated it is called an error of commission
(doing something which should not have been done). The existence or occurrence objective is
most important with regard to assets and revenues. Overstating those two types of accounts
makes the client’s results look better. The client will have less incentive to overstate liabilities
or expenses.
2. Completeness:- relates to both balance sheet and income statement accounts. Have all
transactions for the year been recorded? Another way of expressing this assertion is to say
“none of the accounts on the balance sheet or income statement are understated. If accounts
are understated, it is called an error of omission (not doing some thing which should have
been done)
The completeness objective is most important with regard to liabilities and expenses.
Understating those two types of accounts makes the client’s results look better. The clients
will have less incentive to understate, assets or revenues.
3. Rights and obligations:- this assertion says that the client’s has legal rights to all its assets and
legally owes all its liabilities. This assertion is particular importance to assets. Obligations
may be greater concern in a small business, where the owner may list some of his own
personal liabilities as liabilities of the business.
4. Valuation or Allocation
Valuation: - is more concern for balance sheet has the investments been valued at the lower of
cost or market as appropriate? Is inventory valued by LIFO, FIFO, weighted average or some
other acceptable method? Accounts. Have the fixed assets been properly valued according to
GAAP. Have the investments been valued by LIFO, FIFO, weighed average or some other
acceptable method?
Allocation: - has more to do with income statement accounts. Have revenues and expenses been
allocated to the proper period according to the matching principle? Have factory overhead costs
been allocated to products in inventory rather than charged as expenses?
 5. Presentation anddisclosure
Presentation:- has to do with classification of the amounts on the finical statements. Are
inventories for sale presented as current assets?
Disclosure: - refers to the notes to the financial statements have significant accounting polices
been explained?
Factors to be considered in obtaining Audit Evidence
While obtaining audit evidence through the performance of compliance procedures, the
following assertions should be given importance.
 Existence: - The control which is supposed to exist actually exists.
 Effectiveness:- The control is operating effectively
 Continuity:- The control has operated effectively in an uninterrupted manner
throughout the period of intended reliance.
While obtaining audit evidence through the performance of substantive procedures, the following
assertions should be given importance.
Audit objective Explanation The question to be answered
a. Existence Existence of an asset or liability at a Do the recorded assets and liabilities
given data actually exist?
b. Rights/ownership An assets is aright of the entity and Are the assets owned by the entity and
and obligations a liability is an obligation of the are the liabilities the obligation of the
entity at a given date entity?
c. Occurrence A transaction or event took place, Did the recorded income and expense
which pertains to the entity transaction in fact occur?
d. Completeness There are no unrecorded assets, Have all the assets and liabilities been
liabilities or transactions recorded? Have all and expenses been
recorded?
e. Valuation & An asset or liability is recorded at Have the amounts at tributes to the
Accuracy an appropriate carrying value assets and liabilities been arrived at in
accordance with the stated accounting
polices on an accepted and consistent
basis?
f. Measurement A transaction is recorded in the Have the income and expense been
 proper amount and revenues or measured in accordance with the
expense is allocated to the proper stated accounting policies on an
period acceptable and consist basis? In
particular whether proper allocation is
made between capital and revenue.
g. Presentation and An item is disclosed and described Have the assets, liabilities capital and
discloser in accordance with acceptable reserves as also incomes and expenses
accounting polices and, when been disclosed, classified and
applicable legal requirements described in accordance with
acceptable accounting polices and,
when applicable, legal requirements?

It should clearly be understood in this connection that the auditor will not be justified in
obtaining evidence in respect one of the above assertions while failing to do so in respect of
another. By way of an example, obtaining evidence in respect of the assertion or existence of
stock in trade will not justify the auditor for this failure to obtain evidence in respect of other
assertions such as valuation, completeness, presentation, disclosure, etc of stock in trade.
3.3 THE RELATIONSHIP OF AUDIT RISK TO EVIDENCE
The term audit risk refers to the possibility that the auditors may unknowingly fail to
appropriately modify their opinion on financial statements that are materially misstated. In other
words, it is the risk that the auditors will issue an unqualified opinion of financial statement that
contains a material departure from generally accepted accounting principles. Audit risk is
reduced by gathering evidence the more competent evidence that is gathered the less audit risk
assumed.
Auditors must gather sufficient evidence to reduce audit risk to a low level in every audit. One
obvious way together additional evidence is to increase the extent of the auditor procedures.
However, additional evidence may also be obtained by selecting more effective audit procedures,
or by performing the procedures closer to the balance sheet date. The requirement to obtain
sufficient competent evidence is reflected in the third standard of field work that states.
Sufficient competent evidential matter is to be obtained through inspection observation, inquires,
and confirmation to afford a reasonable basis for or an opinion regarding the financial statements
under audit.
Financial Statement Assertions
Audit procedures are designed to obtain evidence about management’s assertions that are
embodied in the financial statements. When the auditors have gathered sufficient audit evidence
about each material financial statement assertion, they have sufficient evidence to support their
opinion. The financial statement assertions, as summarized in “Evidential matter”, include.
1. Existence or occurrence:- Assets, liabilities, and owners’ equity reflected in the
financial statement exist, the recorded transactions have occurred.
2. Completeness:- All transactions, assets, liabilities, and owners’ equity that should be
presented in the financial statements are included.
3. Rights and obligations:- The client has rights to assets and obligations to pay liabilities
that are included in the financial statements.
4. Valuation or Allocation:- Assets, liabilities, owners’ equity, revenues and expenses are
presented at amounts that are determined in accordance with generally accepted
accounting principles.
5. Presentation and Disclosure:- Accounts are described and classified in the financial
statements in accordance with generally accepted accounting principles and all material
disclosures are provided.
Audit Risk of the Assertion level
Since an audit involves gathering evidence about each material financial statement assertion,
audit risk can be evaluated at the assertion level. For each financial statement account, audit risk
consists of the possibility that
1. Material misstatements in an assertion about the account has occurred and
2. The auditors do not detect the misstatement
The first risk, the rise of occurrence of a materials misstatement, may be separated into two
components that is inherent risk and control risk. The risk that auditors will not detect the
misstatement is called detection risk.
Inherent Risk:- The possibility of a material misstatement of an assertion before considering the
client’s internal control is refereed to as inherent risk. Factors that affect inherent risk relate to
either the nature of the client and its industry or to the nature of the particular financial statement
account. In general, assertions with high inherent risk involve.
 1 Difficult to audit transactions or balances
2 Complex calculations
3 Difficult accounting issue
4 Significant judgment by management or
5 Valuation that vary significantly based on economic factors.
The auditor use their knowledge of the client’s industry and the nature of its operations,
including information obtained in prior year audits, to assess inherent risk for the financial
statement assertions.
Control Risk:- The risk that a material misstatement will not be prevented or detected on a
finely basis by the client’s internal control is referred to as control risk. This risk is entirely based
on the effectiveness of the client’s internal control.
To assess control risk, auditors consider the clients controls, emphasizing those controls that
affect the reliability of financial reporting. Well-designed controls that operate effectively
increase the reliability of accounting data. Errors are prevented or brought to light on a timely
basis by the built-in proofs and cross-checks that are in the system.
To obtain an understanding of the client’s internal control and to determine whether it is
designed and operating effectively, the auditors use a combination of inquiry, inspection,
observation, and report re-performance procedures. If the auditors find that the client has
designed effective internal control for a particular account and that the prescribed practices
operate effectively in day to day operations, they will assess control risk for the related assertions
to be low, and there by accept a higher level of detection risk. Thus the effectiveness of the
client’s internal control is a major factor in determining how much evidence the auditors will to
restrict detection risk.
3.4 MEASURING AUDIT RISK
In practice the various components of audit risk are not typically quantified. Instead, the auditors
usually use quantitative categories, such as low risk, moderate risk, and maximum risk. “Audit
risk and materiality in conducting an audit.” Allows either a quantified or no quantitative
approach, but includes the following formula to illustrate the relationships among audit risk,
inherent risk, control risk, and deduction.
AR = IR X CR X DR
Where:-
AR =
Audit risk CR= Control risk
IR = Inherent risk DR = Detection risk
To illustrate how audit risk may be quantified, assume that the auditors have assessed inherent
risk for a particular assertion is 50 percent and control risk at 40 percent in addition, they have
performed audit procedures that they be live have a 20 percent risk of failing to detect a material
misstatement in the assertion. The audit risk for the assertion may be computed as follows.
AR = IR X CR X DR
= 0.50 x 0.40 x 0.20
= 0.04
Thus, the auditors face a 4 percent audit risk that material misstatement has accrued and evaded
both the client’s controls and the auditors’ procedures. Realize, however, that the model
expresses general relationships and is not necessarily intended to be a mathematical model to
precisely consider the factors that influence audit risk in actual audit situations.
It is important to realize that while auditors gather evidence to assess inherent risk and control
risk, they gather evidence or restrict detection risk to the appropriate level. Inherent risk and
control risk are a function of the client and its operating environment. Regardless of how much
evidence the auditor gather, they can not change the risk. Therefore, evidence gathered by the
auditor is used to assess the levels of inherent and control risk.
Detection risk, on the other hand, is a function of the effectiveness of the audit procedures
performed if the auditors wish to reduce. The level of detection risk, they simply obtain
additional competent evidence. As a result, detection risk is the only risk that is completely a
function of the sufficiency of the procedures performed by the auditors.
We have already seen that an auditor collects sufficient appropriate audit evidence and evaluates
the sum for the purpose of reporting on economic information let us take an example to illustrate
how auditor collects evidence.
Evidence in Auditing:- An Illustration
Let us assume that x runs a small shop to sell bread. Each morning, the bread manufacture
delivers a certain quantity of bread to him, which is sold by him during the day. The selling price
gives him a 25% gross margin over the cost price. Next morning, when x receives fresh supply
of bread, he pays for the previous day’s supply to the bread manufacture. Suppose, you are asked
to audit the transactions of one day.
The first step would be ask x to prepare a statement of account for the day under audit. The
statement may appear as below.
Birr Birr
Cost of bread 240 cash sales 200
Miscellaneous expenses 20 credit sales 100
Profit for the day 40 ____
300 300
As auditor, you have to collect evidence to support the transactions of the day. Let us just think
of the kind of evidence which may be available.
1. You can visit the shop on the morning or the day for which the audit is being conducted
and count the loaves of bread delivered by the manufacture to X
2. You can visit the shop on the evening of the day under audit and count the cash-in-hand
3. You can examine the copy of the challan/ bill given by the manufacture to X while
delivering the bread.
4. You can examine the rough note book maintained by X, giving details of customers to
whom the bread was sold on credit
5. You can take a written or oral statement from the bread manufacturer giving details of
bread supplied to X on the particular day.
6. You can examine the receipt given by the manufacture for the money paid to him by x
the next day.
It is not really necessary for the auditor to collect all the above evidence, nor can it be argued that
the auditor cannot collect some other evidence. The purpose of the above listing is merely to
illustrate the techniques through which the auditor can collect evidence for verifying the
transactions of the day. The different techniques used in this illustrative case to collect evidence
are as below:
a. Physical inspection (steps 1 and 2)
b. Examination of external documents (step 3 and 6)
c. Examination of internal document (step 4)
d. Obtaining statements / certificates from 3rd (third) parties (step 5)
The above illustration how an auditor collects and evaluates evidence. It is important to
understand the nature and types of evidence available in various situations.

Categories of evidence
There are two broad categories of evidence relating to financial statement assertions
A. Underlying accounting data and
B. Corroborating evidential matter
A. Underlying Accounting Data
1. The general ledger
2. Subsidiary ledger (Account receivable , account payable ,fixed assets etc)
3. Accounting manuals :- which tell what type of transactions should go in to which
accounts and any procedures which are necessary
4. Informal and memorandum records .e.g cost allocation worksheet deprecation schedules,
bank reconciliation
B. Corroborating evidential matter
Underlying accounting data are not sufficient by themselves. They need to be corroborated by
the following types of evidence
1. Physical – direct factual evidence of things that can be counted examined observed or
inspected.
2. Confirmation and other written representations by knowledgeable 3rd parties.
3. Documents – e.g checks, invoices, contracts, minutes of the board of directors meetings.
4. Analysts – applied to data to determine relationships e.g financial ratio
3.5 SUFFICIENT AND APPROPRIATE AUDIT EVIDENCE
Sufficiency and appropriateness are interrelated and apply to evidence obtained from both
compliance and substantive procedures. Sufficiency is the measure of the quantity of audit
evidence obtained, appropriateness of audit evidence relates to its relevance and reliability.
Normally, the auditor finds it necessary to rely on evidence that is persuasive rather than
conclusive. He may often seek evidence from different sources or of a different nature to support
the same assertion.
The audit evidence should, in total, enable the auditor to from an opinion on the financial
information. Informing such an opinion, the auditor does not normally examine all of the
information that is available to him because he can reach a conclusion about an account balance,
class of transactions or a control by way of judgmental or stastical sampling procedures
The auditor’s judgment as to what is sufficient and appropriate audit evidence is influenced by
such factors as:-
A. The degree of risk of misstatement
This risk may be affected by:-
i. the nature of the item
ii. the adequacy of internal control
iii. the nature of the business carried on by the entity
iv. situations which may exert an unusual influence on management, and
v. the financial position of the enterprise
B. The materiality of the item in relation to the financial information taken
as a whole.
C. The experience gained during previous audits
D. The results of auditing procedures, including fraud or error which may have been found, and
E. The type of information available
3.6 METHODS OF OBTAINING AUDIT EVIDENCE
The auditor obtains evidence through compliance and substantive procedures by one or more of
the following methods:-
1. inspection 4. computation and
2. observation 5. analytical view
3. inquiry and confirmation
The above points are briefly explained below
1. Inspection: - inspection consists of examining records, documents or tangible assets.
Inspection of records and documents provides evidence of varying degree of reliability
depending on their nature and source and the effectiveness of internal controls over their
processing. Three major categories of documentary evidence, which provide different
degrees of reliability to the auditor, are
i. documentary evidence created and held by third parties
ii. documentary evidence created by third parties and held by the entity, and
iii. documentary evidence created and held by the entity
Inspection of tangle assets provides reliable evidence with respect to the existence but not
necessarily as to their ownership or value:
2. Observation: - observation consists looking of at a process or procedure being performed by
others. Example, the auditor may observe the counting of inventories by client’s personnel or
the performance of internal control procedures that leave no scope for audit trial.
3. Inquiry and confirmation: - inquiry consists of seeking appropriate information of
knowledgeable persons in side or outside the entity. Inquiries may range from formal written
inquiries addressed to third parties to informal oral inquiries addressed to persons inside the
entity. Confirmation consists of the response to an inquiry to corroborate information
contained in the accounting records. For example, the auditor normally requests confirmation
of receivables by direct communication with debtors.
4. Computation: - computation consists of checking the arithmetical accuracy of source
documents and accounting records or of making independent calculations.
5. Analytical review: - analytical review consists of studying significant ratios and trends and
investigating unusual fluctuations and items.
Commencement of a new audit
Before the commencement of a new audit, the following instruction must be given by the
auditor to his client:
1 A complete list of books in use together with a list of employees engaged upon them with
their respective duties, a note on the system of book keeping in operation and a statement of
the system of internal control in practice should be provided to the audit staff.
2 All the books of original entry should be totaled and all the legers should be balanced. The
final trial balance and the draft final account should be kept ready for audit examination.
3 All supporting vouchers to all the books should be kept properly arranged.
4 Supporting schedules to the draft accounts, schedule of debtors and creditors, schedule of bad
and doubtful debts, schedule of outstanding assets and liabilities in respect of accrued
income, unpaid expenditure, prepaid expenses or income received in a advance, schedule of
investments, detailed inventory sheet, in respect of stock and fixed assets, schedule of share
capital, etc. should be prepared and kept in final form.
Before commencing the audit, some of the auditors prepare a job information sheet.
Test Checking
Test checking as the expression implies is a method of examining a selected number of items.
The concept of test checking in auditing is based on the law of statistical inertial which means
the selection and checking of a representative number of entries of each class of transactions
instead of going through each and every entry.
The following precautions must be taken by the auditor while carrying a test-check of the
transactions.
1. While making selection for test-checks, every effort must be made to ensure that the
entries are representative of the whole set of books
2. The clients should not be knowing the period selected for the test check
3. The month selected for test check should be different in forthcoming year
4. The first and the last months of the period covered by the accounts may perfectly be
checked in every case.

Routine Checking
Auditing is basically a process of verification of accuracy and propriety of financial statements.
This invariably needs checking the correctness or otherwise of the books of account and
transaction. There are certain records and books which are common to all types of business
undertakings irrespective of size, constitution and nature of activities and transactions of a
business. The checking of such common records and books is known as routine checking.
Routine checking is carried on by the auditor as a matter of routine and includes the following
four functions.
1. Checking of costings, Sub costings; carry forwards and other calculations in the books of
original entry.
2. Checking of postings in the ledger accounts
3. Checking of castings and balances of various ledger accounts and
4. Checking of transfer of balances from the ledger to the trial balance

Routine Checking is different from test checking

Routine checking is a detailed and extensive method of checking applied for verification of each
and every item of books of account where as test checking refers to examination of a selected
number of items. Test checking is therefore based on a selective examination of transaction with
a view to avoid verification of items of immaterial importance so far as the purpose of auditing is
concerned. Routine checking on the other hand is directed to check all the transactions with out
exception.

Silent Features o routine checking

1. Defined checking :- Routine checking is detailed checking of each and every transaction
as recorded in the books of original entry and the subsidiary books, and all ledger
postings besides transfer to balance from ledges to the trial balance
2. Traditional system:- it is a traditional system of audit
3. Checking of each and every item: - in a routine checking all efforts re directed to check
transactions without exception.
4. Method of extensive checking: - By routine checking we traditionally think of extensive
checking and vouching of all entries.
5. Expensive: - The process of routine checking is expensive in terms of time as well as
cost. It takes more time and consumes higher cost.
6. Defects clerical error and fraud of a very ordinary nature:- routine checking can
reveal the clerical errors and ordinary frauds. It does not necessarily discover errors and
frauds of material importance.
Advantages of Routine Checking
Routine checking offers the following advantages
1. Thorough checking of transactions:- in routine checking, the books of original entry
can be checked thoroughly and errors and frauds can be sporffed easily.
2. Constitutes important base: - it constitutes as important base of the entire audit as it
involves a thorough examination of all transactions without exception from the books of
original entry up to the ledgers.
3. Facilitates the verification on the arithmetical accuracy of the transactions:- routine
checking does reveal not only the errors and frauds of a simple nature but if carried on
with due care and precaution, it helps in the verification of the arithmetical accuracy of
the entries.
4. Easy to perform: - routine checking is a simple job which can be performed easily by a
person having ordinary knowledge of accountancy it involves the work of an elementary
nature.