CHAPTER FIVE

AUDIT EVIDENCE

Content

5.1. Meaning of audit evidence

5.1. Financial statement assertions
5.3. Types of audit evidence
5.4. Relationship of Audit evidence to audit risk
5.5. Working paper

INTRODUCTION
The foundation of any audit is the evidence obtained and evaluated by the auditor. The auditor
must have the knowledge and skill to accumulate sufficient appropriate evidence on every audit
to meet the standards of the profession. This chapter deals with the types of evidence decisions
auditors make, the evidence available to auditors, and the use of that evidence in performing
audits and documenting the results.
5.1. MEANING OF AUDIT EVIDENCE

The third standard of field work requires an auditor to collect sufficient and competent
evidence, which is the very essence of auditing and forms the basis for issuing audit opinion.
Evidence is equally important for scientists, medical practitioners, lawyers and public
accountants. When an auditor is accused of negligence his guilt or innocence is proved on the
basis of sufficiency and competence of evidential matter.

Audit evidence (also referred to as evidential matter) refers to the necessary information that an
auditors gathers in order to form a credible opinion on the assertions by client’s management that
are inherent in the financial statements.

5.1.1. Nature of Audit Evidence

Audit evidence is any information or document that confirms or rejects a premise (a statement or
hypothesis). The auditor’s premise is that financial statements present fairly the financial
position and operating results of the business.

The information that an auditors gathers varies greatly in the extent to which it persuades the
auditor whether financial statements are fairly stated. Evidence includes information that is
highly persuasive, such as the auditor’s count of marketable securities, and less persuasive
information, such as responses to questions of client employees. Thus, it recognizes that the
accumulation of evidence should be persuasive rather than convincing. In general, the two

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determinants of the persuasiveness of evidence are Competence (i.e. appropriateness) and
sufficiency

COMPETENCE of evidence is a relative term and refers to its quality or reliability. To be

competent evidence must be valid and relevant. Competence or appropriateness of evidence is a
measure of the quality of evidence, meaning its relevance and reliability in meeting audit
objectives for classes of transactions, account balances, and related disclosures. If evidence is
considered highly appropriate, it is a great help in persuading the auditor that financial
statements are fairly stated.

Note that appropriateness of evidence deals only with the audit procedures selected.
Appropriateness cannot be improved by selecting a larger sample size or different population
items. It can be improved only by selecting audit procedures that are more relevant or provide
more reliable evidence.

SUFFICIENCY refers to the quantity of evidence to be obtained. It is a matter of professional

judgment. The quantity of evidence obtained determines its sufficiency. Sufficiency of evidence
is measured primarily by the sample size the auditor selects. For a given audit procedure the
evidence obtained from a sample of 100 is ordinarily more sufficient than from a sample of 50.

Several factors determine the appropriate sample size in audits. The two most important ones are
the auditor’s expectation of misstatements and the effectiveness of the client’s internal controls.
To illustrate, assume in the audit of Jones Computer Parts Co. that the auditor concludes that
there is a high likelihood of obsolete inventory because of the nature of the client’s industry. The
auditor will sample more inventory items for obsolescence in this audit than one where the
likelihood of obsolescence is low. Similarly, if the auditor concludes that a client has effective
rather than ineffective internal controls over recording fixed assets, a smaller sample size in the
audit of acquisitions of fixed assets may be warranted.

In addition to sample size, the individual items tested affect the sufficiency of evidence. Samples
containing population items with large dollar values, items with a high likelihood of
misstatement, and items that are representative of the population are usually considered
sufficient. In contrast, most auditors usually consider samples insufficient that contain only the
largest dollar items from the population unless these items make up a large portion of the total
population amount.

5.2. MANAGEMENT ASSERTIONS

These are implied or expressed representations by management about all the transactions and
balances appearing in financial statements. Management assertions are directly related to GAAP
and can be divided into the following groups.

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  Existence or Occurrence: assets, liabilities and equity exist in fact and transactions
appearing in the records actually occurred during the accounting period.
 Completeness: it asserts that all transactions and accounts that should be presented in
financial statements are included. Recording of sale that didn’t take place is violation of
existence while, failure to record the sales that took place is violation of completeness.
 Valuation or Allocation: all assets, liabilities, equity, revenue and expense are included
in the financial statement at appropriate amounts. Fixed assets are properly depreciated
and account receivable represents the net realizable value.
 Rights and Obligations: assets are owned by the company and liabilities are owed
infact.
 Presentation and Disclosure: components of the financial statements are properly
combined or separated; described and disclosed. Long-term and short-term liability,
extra ordinary items, other incomes and expenses etc.

5.3. TYPES OF AUDIT EVIDENCE

In deciding which audit procedures to use, the auditor can choose from eight broad categories of
evidence, which are called types of audit evidence. Every audit procedure obtains one or more of
the following types of audit evidence:
1. Physical Evidence
2. Documentary Evidence
3. Accounting Records
4. Analytical procedures
5. Computations
6. Evidence provided by specialists
7. Oral Evidence
8. Client’s letter of representations

1. Physical Evidence: physical observation or count provides evidence to the existence of certain
assets such as cash, inventories, equipment, building etc. however, it is needed to gather
additional evidence to determine ownership, valuation and condition (salable, obsolete) of the
assets. If there is any doubt regarding such matters, auditor must seek help of an expert.
2. Documentary Evidence: auditors rely much on documentary evidence, which consists of the
following;
 Documentary evidence created outside the organization and obtained directly by
the auditors: such evidence doesn’t pass through client’s procedure and is much
dependable. Cash in bank, accounts receivables and other investments, pending litigation
etc. may be verified by having a written communication with concerned party and
requesting to submit the response directly to auditors.
 Documentary evidence created outside the organization and held by the client: bank
statements, vendor invoices, notes receivables, contruct agreements, purchase order of

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 customers, shares and bond certificates are some of such evidence used extensively by
the auditor. However, care should be taken to determine reliability of such sources by
considering susceptibility of such evidence to be created or altered.
 Documentary evidence created and held within the organization: the most reliable
evidence of such type is paid checks, sales invoices, and purchase orders, receiving
reports, credit memorandums are a few documents created and kept within the
organization. Reliability of such evidence largely depends on the adequacy of internal
control. Proper record keeping and extensive subdivision of work may increase
reliability of such evidence. While using such evidence auditors must be careful about
fraud conceived by employees and management.

3. Accounting Records as evidence: an amount appearing in financial statements may be verified

by tracing it back through ledger, journal and source documents. When record keeping is
monitored by good internal control it provides reliable support for financial statements. When
different persons maintain general ledger, subsidiary ledgers and journal, reliability will be
more. However, the auditor must be careful about alteration and misstatements.

4. Analytical procedures: these are used to establish reliability of information by analyzing

relationships among financial and other information. It involves determining an expected or
desired balance; determine the tolerance level (expected deviation without investigation). After
comparing the above two, if significant deviation is found, it should be investigated properly.
The analytical procedure may involve a variety of techniques from simple to complex including
horizontal analysis, intra firm comparison and relationship with non-financial data (units
produced, hours worked etc.) ratio, percentage, regression analysis, trend analysis and other
complex models involving variety of data are used extensively for the purpose. If the result is
found as expected or there is insignificant deviation, it is evidenced that the information is free
from material misstatement, when the deviation is more, it should be examined fully.

4.1. Comparison with industry average (also called horizontal analysis): it help to
understand client’s strength and weakness in comparison to similar companies.
However, auditors must be careful on comparability (size, accounting method, other
business etc.)
4.2. Comparison with internal data (also called trend or vertical analysis): it forecasts,
production reports, monthly performance report etc. must be used to develop
relationship with actual figures and determine the reliability.
5. Computations: auditor can independently do computations to verify accuracy of items such
as account totals and balances. It may be used to prove accuracy of calculations such as EPS,
depreciation expenses, allowance for uncollectible accounts, revenue recognized on
percentage of completion basis etc.
6. Evidence provided by specialists: auditors are not expected to have expertise in areas such
as judging the quality of inventory, making actuarial computations for pension liabilities,
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 probable outcomes of litigation, estimating the reserves of natural resources, etc. Therefore,
they should seek the help of experts; however, they are expected to ensure competence and
independence of the expert and reliability of the expert opinion in given situation.

7. Oral Evidence: during the audit auditors (CPAs) ask a lot of questions regarding location of
records and documents, logic behind adopting or not adopting a particular accounting
procedure, possibility of collecting amounts due for long time, probable liability in case of
litigation etc. through the oral investigation is not sufficient in itself, it points out the
situation that requires more investigation or collecting more evidence.

8. Client’s letter of representations: at the end of field work auditors obtain a written letter of
representations from the client, verifying oral representations, falling into following
categories:
(1) All the relevant records are were made available to auditors
(2) Financial statements are complete and prepared in conformity with GAAP, and
(3) All items requiring disclosures (contingencies, illegal acts etc.) have been disclosed
properly.
Though the Client’s letter of representations is not a substitute of other audit procedures or
evidence, it reminds client of the primary and personal responsibility for financial statements,
documents the client’s responses and helps to know management’s future intentions.

5.4. THE RELATIONSHIP OF AUDIT EVIDENCE TO AUDIT RISK (AUDIT

EVIDENCE VS AUDIT RISK)

There is strong relationship (high Degree correlation) between the audit risk and the types of
evidence to be collected to form an opinion regarding fairness of financial statements. While
determining competence and sufficiency of evidence, auditors must consider the audit risk i.e.
possibility of misstatement and their failure to detect it and issuing inappropriate opinion.
The audit risk includes inherent risk (possibility of material misstatement assuming absence of
internal control) and detection risk (the risk that audit procedures may lead to a conclusion that
there is no material misstatement, when in fact accounts are materially misstated). While
planning the audit and determining the evidence requirement, the auditor must assess the degree
of inherent and control risks for each material items. Accordingly they should plan the audit
procedures and quantity and quality of evidence required to minimize detection risk by
collection of enough competent evidence. On the basis of audit risks, the evidence required to
minimize them may be of following types:

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Audit Risk and Audit Evidence: the susceptibility of assets and other accounts, to errors and
frauds contributes to inherent risk. While determining the evidence to be gathered, auditor must
consider such risks and act accordingly. The quantity and quality of evidence required to
establish accuracy of cash is more than that required for plant assets such as buildings. In case
the circumstances warrants about the possibility of fraud or misstatement, auditor must be
prudent and gather more and more evidence.

Control Risk and Audit Evidence: conducting the complete audit, i.e. examining each invoice,
cheque or other documentary evidence is not feasible. Therefore, it is required to test adequacy
and effectiveness of the methods and procedures adopted by the company to control its
accounting process, so that auditor can do with sample audit.

TYPES OF RISKS

Audit risk: is the risk that the auditor’s may unknowingly fail to appropriately modify their
opinion on financial statements that are materially misstated. Audit risk is the chance that a
material misstatement exists in the financial statements and the auditors do not detect the
misstatement with their audit procedures. Audit risk can be decomposed in to the three
components.

1. Inherent Risk: is the risk of material error in an account,assuming there were no related
internal control.
2. Control Risk: is the risk of material error occurring in an account and not being prevented or
detected on timely basis by the internal control structure.
3. Detection Risk: the risk that the auditors’ procedures will lead them to conclude that a
material misstatement does not exist in an account balance when in fact the account is
materially misstated.
Detection risk relates directly to the effectiveness of the auditor’s procedures, but inherent
and control risk are functions of the client and its environment. In planning and collecting
audit evidence, the auditors must assess the extent of inherent and control risk for each
material financial statement balances, and then plan sufficient audit procedures to reduce
detection risk to the appropriate level.

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 If the firm’s internal control mechanism is effective, then control risk is low and detection
risk may be high, because the auditor may depend on the internal control system and fail to
properly plan and design his audit procedures.

EVIDENCE PROVIDED BY SUBSEQUENT EVENTS

Evidences not available at the close of the period under audit sometimes become available
before the auditors finish their field work and write their audit report. The auditor’s opinion
on the fairness of the financial statements may be changed considerably by these subsequent
events.
The term subsequent event refers to an event or transaction that occurs after the date of the
balance sheet but prior to the completion of the audit and issuance of the audit report.
Subsequent events may be classified in to two broad categories
1. Those providing additional evidence as to facts existing on or before the balance sheet
date; and
2. Those involving facts coming in to existence after the balance sheet date

The first type of subsequent events provides additional evidence as to conditions that existed
at the balance sheet date and affects the estimates inherent in the process of preparing
financial statements. These types of subsequent events require that the financial statements
amounts be adjusted to reflect of the changes in estimates resulting from the additional
evidence.

Example 1: Assume the large amount of receivable due from the client’s major customers was
regarded as good and collectible at year end, but during the course of the audit engagement the
customer entered bankruptcy.

 The bankruptcy of the customer shortly after the balance sheet date indicates
that the client was simply in error in believing the receivables to be good and
collectible
 Hence, the auditor should insist an increase in the Dec 31 allowance for
uncollectible accounts.

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Example 2: Litigations are disclosed in notes to financial statements, if these pending litigations
are settled shortly after the balance sheet date; the actual liability should be reported on the
balance sheet.

The second type of subsequent event involves conditions coming in to existence after the balance
sheet date. These events do not require adjustment to the financial statement amount, but should
be disclosed to the financial statement.

Subsequent events having significant impact on the company’s financial position should be
disclosed in foot notes.

Examples:

If the client sustains an uninsured fire loss destroying most of its plant assets, shortly after the
balance sheet date, but during the course of audit engagement, the carrying value of plant assets
should not be reduced, because these assets were correct at the end of the year. However, the
event should be disclosed to the financial statement as foot note.

Other Examples:

 Business combination with other company

 Death of company’s key official
 Introduction of new product line
 Plant closed by a labour strike

AUDIT WORKING PAPER

Defn: Working papers refers to the papers prepared by the auditor for audit work as well as the
documents, statements, and recorded information obtained by the auditor from his client and
others connected with the business.

 Working papers are the written private materials which an auditor prepares for each
audit. It describes the accounting information which an auditor receives from the client,
the method of examination, his conclusions and the reasons there of and the financial
statements.

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  Working paper provide basic evidence of audit conducted in accordance with standard
audit practices. They help the auditor in writing the report.
 Working papers are the connecting links between the client’s accounting record and the
auditor’s report.

FUNCTIONS OF WORKING PAPERS

Audit working papers assist auditors in several ways

1. It provides a means of assigning and coordinating audit work

2. It helps the seniors in supervising and reviewing the work of assistants
3. It supports the audit report
4. It helps the auditor to show his client the weakness of the internal control system
5. It is a permanent record and incase of any suit against him for negligence he can defend
himself on the basis of these working papers
6. It helps for planning and conducting the next audit

CONTENTS OF WORKING PAPERS

Working paper normally includes the following
 Audit program
 Copies of the documents received
 Schedule of receivables, payables, fixed assets and investments
 Copies of the correspondence concerning the audit work
 Contract letter from the letter
 Particular of deprecations
 Copies of the previous audit reports
 Copies of the resolutions passed in the meeting of directors and shareholders
 Certificates of management assertions
 Details of the questions made during the course of audit and their explanation
given.
 Other necessary document received for the conduct of the audit work.

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OWNERSHIP OF WORKING PAPERS

The audit working papers being matters documented and prepared by the auditor are the
property of the auditors, not of the client. The client does not have the right to demand access to
the auditor’s working papers. After the audit, the working papers are retained by the auditors.

Confidential nature of Working papers

To conduct a satisfactory audit the auditors must be given unrestricted access to all information
about the client’s business. Much of this information is confidential (e.g. profit margin from
individual products, tentative plan for business combinations, salaries of key officials and
employees etc.).

 Much of the information gained by the auditor is recorded in their working papers.
Consequently, the working papers are confidential in nature; hence, the auditors
shall not disclose any confidential information obtained in the course of a
professional engagement except with consent of the client.

WORKING PAPERS AND AUDITORS LIABILITY

The auditor’s working papers are the principal record of the extent of the procedures applied and
evidences gathered during the audit. If the auditors are charged with negligence, their audit
working paper will be major factors for refuting the charge.

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