AUDIT

EVIDENCE
WEEK 3

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 CHAPTER 7 LEARNING OBJECTIVES
7-1 Contrast audit evidence with evidence used by other professions.
7-2 Identify the four audit evidence decisions that are needed to
create
an audit program.
7-3 Specify the characteristics that determine the persuasiveness of
evidence.
7-4 Identify and apply the eight types of evidence used in auditing.
7-5 Know the types of analytical procedures and their purposes.
7-6 Compute common financial ratios.
7-7 Understand the purposes of audit documentation.
7-8 Prepare organized audit documentation.

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 OBJECTIVE 7-1
Contrast audit evidence with evidence
used by other professions.

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 NATURE OF EVIDENCE
Table 7-1 contrasts audit evidence with legal and
scientific evidence.

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 OBJECTIVE 7-2
Identify the four audit evidence
decisions that are needed to create
an audit program.

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 AUDIT EVIDENCE DECISIONS
The auditor must make four major decisions
regarding what evidence to gather and how much to
accumulate:
1. *Which audit procedures to use?
2. What sample size to select for a given procedure?
3. Which items to select from the population?
4. When to perform the procedures?
An audit program includes all of the above
information for a given audit.
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 OBJECTIVE 7-3
Specify the characteristics that determine
the persuasiveness of evidence.

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 PERSUASIVENESS OF EVIDENCE

Audit standards require that the auditor accumulate

sufficient appropriate evidence to support the opinion
issued.
The two determinants of the persuasiveness of evidence
are appropriateness and sufficiency.
Appropriateness of evidence depends on:
• Relevance of evidence
• Reliability of evidence

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 PERSUASIVENESS OF EVIDENCE (CONT.)

*Relevance of evidence means that the evidence must

pertain to or be relevant to the audit objective that is being
tested.
Reliability of evidence refers to the degree to which evidence is
believable or worthy of trust. Reliability depends on the following
characteristics:
1. Independence of provider
2. Effectiveness of client’s internal controls
3. Auditor’s direct knowledge
4. Qualifications of individuals providing the information
5. Degree of objectivity
6. Timeliness

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 PERSUASIVENESS OF EVIDENCE (CONT.)

*Sufficiency of evidence refers to the quantity of evidence obtained.

The sample size that is considered sufficient is affected by two
factors:
• The auditor’s expectation of misstatements
• The effectiveness of the client’s internal controls
Combined Effect—The persuasiveness of the evidence can be
evaluated only after considering the combination of
appropriateness and sufficiency.

In making decisions about audit evidence, both persuasiveness and

cost must be considered. The relationships among evidence
decisions and persuasiveness are illustrated in Table 7-2.

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 OBJECTIVE 7-4
Identify and apply the eight types of
evidence used in auditing.

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 TYPES OF AUDIT EVIDENCE
Every audit procedure obtains one or more of the following types
of evidence:
1. Reperformance
2. Inquiry
3. Observation
4. Recalculation
5. Inspection
6. Confirmation
7. Analytical procedure
Relationships among auditing standards, types of evidence, and the four
audit evidence decisions are shown in Figure 7-1.

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 TYPES OF AUDIT EVIDENCE (CONT.)

1. Reperformance—The auditor’s test of client accounting procedures or controls.

2. Inquiry—Obtaining written or oral information from the client in response to auditor
questions. Usually not considered conclusive unless it is corroborated.
3. Observation—Watching a process or procedure being performed by others.
4. Recalculation—Rechecking a sample of calculations made by the client.
5. Inspection—The auditor’s examination of the client’s documents and records to
substantiate the information in the financial statements.
• Documents can be internal (prepared by the client’s organization) or external
(prepared or handled by someone outside the organization who is a party to the
transaction).
• Using documents to support recorded transactions (occurrence) is called
vouching.
• Testing from source documents to recorded amounts (completeness objective) is
called tracing.

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 TYPES OF AUDIT EVIDENCE (CONT.)
6. Confirmation—The receipt of a direct written response from a third party verifying the
accuracy of information that was requested by the auditor. Information often confirmed is
detailed in Table 7-3.
7. Analytical Procedures—The evaluation of financial information through analysis of plausible
relationships among financial and nonfinancial data and are required during planning and
completion phases of all audits. Purposes of analytical procedures include:
• Understand the Client’s Industry and Business—Used in planning to gain knowledge
about the client.
• Assess the Entity’s Ability to Continue as a Going Concern—Many ratios can be an
indicator of potential financial problems.
• Indicate the Presence of Possible Misstatements in the Financial Statements—The
presence of unusual fluctuations noted in comparing current and prior years could
signal misstatements.
• Provide Evidence Supporting an Account Balance—If reliable relationships exist,
substantive analytical procedures can be used to support account balances.

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 TYPES OF AUDIT EVIDENCE (CONT.)

Cost of Types of Evidence:

• Most expensive:
• Confirmation
• Moderately costly:
• Reperformance
• Inspection
• Analytical procedures
• Least expensive:
• Recalculation
• Inquiries of the client
• Observation

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 OBJECTIVE 7-5
Know the types of analytical procedures
and their purposes.

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 ANALYTICAL PROCEDURES
Purposes of Analytical Procedures During the Audit Engagement:
1. Analytical procedures are required in the planning phase as
part of risk assessment to understand the client’s business
and industry.
2. Analytical procedures are often done during the testing
phase of the audit as substantive tests in support of an
account balance.
3. Analytical procedures are required during the completion
phase of the audit, serving as a final review for material
misstatements.

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 ANALYTICAL PROCEDURES (CONT.)

Types of Analytical Procedures—Auditors compare client data with:

1. Industry data
2. Similar prior-period data
3. Client-determined expected results
4. Auditor-determined expected results

Internal comparisons and relationships are detailed in Table 7-6.

An example of a substantive analytical procedure is included in Figure 7-2.

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 OBJECTIVE 7-6
Compute common financial ratios.

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 COMMON FINANCIAL RATIOS
Financial ratios fall into several categories:
• Short-Term Debt-Paying Ability:
• Cash ratio
• Quick ratio
• Current ratio
• Liquidity Activity Ratios:
• Accounts receivable turnover
• Days to collect receivables
• Inventory turnover
• Days to sell inventory

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 COMMON FINANCIAL RATIOS (CONT.)

• Ability to Meet Long-Term Debt Obligations:

• Debt to equity
• Times interest earned
• Profitability Ratios:
• Earnings per share
• Gross profit percentage
• Profit margin
• Return on assets
• Return on common equity

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 OBJECTIVE 7-8
Prepare organized audit documentation.

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 AUDIT DOCUMENTATION
Audit documentation is the record of the audit procedures
performed, relevant audit evidence, and conclusions the auditor
reached.
*Purposes of Audit Documentation:
• Basis for planning the audit
• Record of the evidence accumulated and the results of the tests
• Data for determining the proper type of audit report
• Basis for review by supervisors and partners

Ownership of the Audit Files: All audit files are the property of
the auditor.
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 AUDIT DOCUMENTATION (CONT.)

Confidentiality of Audit Files:

The AICPA Code of Professional Conduct states that a member in public
practice shall not disclose any confidential client information without the
specific consent of the client.
Requirements for Retention of Audit Documentation:
• Auditing standards require records of private companies be retained
for a minimum of five years.
• Sarbanes-Oxley Act requires auditors of public companies to maintain
audit files for a minimum of seven years.

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 AUDIT DOCUMENTATION (CONT.)

The contents and organization of a typical set of audit files is illustrated in

Figure 7-3. The type of audit documentation and the way it is arranged in the
files is logical although firms may vary in their approaches.
Permanent Files: Contain data of a historical or continuing nature. These
provide a convenient source of information that is used from year to year:
• Copies of company documents such as articles of incorporation, bylaws, bond
indentures, and long-term contracts
• Analyses of accounts from previous years that have continuing importance
• Information related to understanding internal controls and assessing control
risk
• Results of analytical procedures from prior years’ audits for comparison

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 AUDIT DOCUMENTATION (CONT.)
Current Files: Includes all documentation for the current year audit including:
• Audit Program
• Working Trial Balance—Each line in the trial balance is supported by a lead
schedule. A typical lead schedule for Cash is included in Figure 7-4.
• Adjusting Entries—Auditors propose adjusting entries for material
misstatements. An adjusting entry to Cash is illustrated in Figure 7-4.
• Supporting Schedules—Major types:
• Analysis
• Trial balance or list
• Reconciliation of amounts
• Substantive analytical procedures
• Summary of procedures
• Examination of supporting documentation
• Informational
• Outside documentation
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 AUDIT DOCUMENTATION (CONT.)

Preparation of Audit Documentation—Audit documentation should be in

sufficient detail to provide a clear understanding of the work performed,
evidence obtained, and conclusions reached.
Documentation should have these characteristics:
• Identified with the client’s name, period covered, description of the
contents, initials of the preparer, date of preparation, and an index
code.
• Files should be indexed and cross-referenced to aid in organization.
• Documentation should clearly indicate the audit work performed
through memos, initialing the procedures in the audit program, or tick
marks on the schedules.
• Include sufficient information to fulfill the audit objectives.
• Conclusions reached about the segment of the audit should be clearly
stated.

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 QUESTION 1
Which of the following types of audit evidence is the most persuasive?
a) Prenumbered client purchase order forms.
b) Client work sheets supporting cost allocations.
c) Bank statements obtained from the client.
d) Client representation letter.

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 QUESTION 2
Which of the following statements relating to the appropriateness of audit
evidence is always true?
a) Audit evidence gathered by an auditor from out- side an enterprise is
reliable.
b) Accounting data developed under satisfactory conditions of internal
control are more relevant than data developed under unsatisfactory
internal control conditions.
c) Oral representations made by management are not valid evidence.
d) Evidence gathered by auditors must be both valid and relevant to be
considered appropriate.

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 QUESTION 3
Which of the following types of audit evidence is the least persuasive?
a) Prenumbered purchase order forms.
b) Bank statements obtained from the client.
c) Test counts of inventory performed by the auditor.
d) Correspondence from the client’ s attorney about litigation.

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 QUESTION 4
In determining whether transactions have been recorded, the direction of
the audit testing should be from the
a) General ledger balances.
b) Adjusted trial balance.
c) Original source documents.
d) General journal entries.

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 QUESTION 5
An auditor should perform alternative procedures to substantiate the
existence of accounts receivable when
a) No reply to a positive confirmation request is received.
b) No reply to a negative confirmation request is received.
c) Collectibility of the receivables is in doubt.
d) Pledging of the receivables is probable.

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 QUESTION 6
An auditor most likely would make inquiries of production and sales
personnel concerning possible obsolete or slow-moving inventory to
support management’s financial statement assertion of
a) Valuation.
b) Rights.
c) Existence.
d) Presentation.

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 QUESTION 7
The refusal of a client’s attorney to provide information requested in an
inquiry letter generally is considered
a) Grounds for an adverse opinion.
b) A limitation on the scope of the audit.
c) Reason to withdraw from the engagement.
d) Equivalent to a significant deficiency.

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 QUESTION 8
Which of the following is a general principle relating to the reliability of audit
evidence?
a) Audit evidence obtained from indirect sources rather than directly is
more reliable than evidence obtained directly by the auditor.
b) Audit evidence provided by copies is more reliable than that provided by
facsimiles.
c) Audit evidence obtained from knowledgeable independent sources
outside the client company is more reliable than audit evidence
obtained from non-independent sources.
d) Audit evidence provided by original documents is more reliable than
audit evidence generated through a system of effective controls.

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