5-1 copyright © 2016 mcgraw-hill education. all rights reserved. no reproduction or distribution...

5-1

Chapter 05

Audit Evidence andDocumentation

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

5-2

Audit Risk

The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated This is the risk that the auditors will issue an

unqualified opinion on financial statements that contain a material departure from GAAP.

Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.


5-3

Financial Statement Assertions

Relevant assertions are those that, without regard for controls, have a reasonable possibility of containing a material misstatement; types Assertions about account balances (Accounts) Assertions about classes of transactions and

events (Transactions) Assertions about presentation and disclosure

(Disclosures)


5-4

Financial Statement Assertions: Auditing

Standards Board and International Standards

Accounts Transactions Disclosures

Existence Occurrence Occurrence

Rights and obligations

Rights and obligations

Completeness Completeness Completeness

Valuation and allocation

Accuracy Accuracy and valuation

Cutoff

Classification Classification and understandability


5-5

Combined Assertions Used in this Text

Existence or Occurrence—Assets, liabilities, and equity interests exist and recorded transactions have occurred

Rights and Obligations—The company holds rights to the assets, and liability are the obligations of the company

Completeness—All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded

Cutoff—Transactions and events have been recorded in the correct accounting period

Valuation, Allocation and Accuracy—All transactions, assets, liabilities and equity interests are included in the financial statements at proper amounts

Presentation and Disclosure—Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressed


5-6

Audit Risk

Risk of Material Risk Auditors Fail Audit Risk = Misstatement to Detect Material

Misstatement

= Inherent Control Detection Risk Risk Risk

Inherent Risk—Risk of a material misstatement occurring in an assertion assuming no related internal controls.

Control Risk—Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control.

Detection Risk—Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.


5-7

Audit Risk Formula

AR = IR * CR * DR

AR = Audit riskIR = Inherent riskCR = Control riskDR = Detection risk


5-8

Audit Risk Figure 5.2


5-9

Inherent Risk

Factors that affect inherent risk: Nature of the client and its environment Nature of the particular financial statement

element Business characteristics indicative of high

inherent risk: Inconsistent profitability of client Operating results highly sensitive to economic factors Going concern problems Large known and likely misstatements detected in prior

audits Substantial turnover, questionable reputation, or

inadequate accounting skills of management


5-10

Assertions with high inherent risk

Involve: Difficult to audit transactions or balances Complex calculations Difficult accounting issues Significant judgment by management Valuations that vary significantly based on

economic factors


5-11

Types of Transactions

Routine Recurring financial statement activities recorded in the

accounting records in the normal course of business Lower inherent risk

Nonroutine Involve activities that occur only periodically such as

the taking of physical inventories High inherent risk

Estimation transactions Activities that create accounting estimates Higher inherent risk


5-12

Appropriateness of Audit Evidence

Auditor must obtain sufficient appropriate audit evidence.

To be appropriate audit evidence must be: Relevant Reliable

Principles—Audit evidence is ordinarily more reliable when it is Obtained from knowledgeable independent sources

outside the company rather than nonindependent sources

Generated internally through a system of effective controls rather than ineffective controls.

Obtained directly by the auditor rather than indirectly or by inference

Documentary in form rather than oral Provided by original documents rather than copies


5-13

Overall Categories of Audit Procedures

Risk assessment procedures To obtain an understanding of the client and

its environment, including its internal control, to assess the risks of material misstatement

Further Audit Procedures Tests of controls

When appropriate, to test the operating effectiveness of controls in preventing material misstatements

Substantive procedures To detect material misstatements at relevant assertion

level. Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosures


5-14

Types of Audit Procedures

1. Inspection of records and documents2. Inquiry of knowledgeable persons within or

outside the entity3. External confirmation4. Inspection of tangible assets5. Observation of processes or procedures

being performed by others6. Recalculation of mathematical accuracy.7. Reperformance of procedures8. Analytical procedures


5-15

Audit Procedures and Examples Figure 5.3


5-16

Substantive Procedures Analytical procedures Tests of details

Tests of account balances Tests of classes of transactions Tests of disclosures

One may change the scope of audit procedures by changing the (NTE, or re-ordered as NET): Nature (type and form) Timing (when performed) Extent (quantity of evidence obtained)


5-17

Nature and Timing of Procedures

Holding the extent of procedures constant, one may increase the scope of procedures (make them more effective) by either changing the Nature—obtain more reliable evidence

often externally generated evidence. Timing—wait until year-end to obtain evidence

from entire set of transactions as contrasted to performing interim testing, say two months prior to year-end and simply updating those procedures.


5-18

Extent of Procedures

Holding other factors such as the nature and timing of procedures constant: The greater the risk of material misstatement,

the greater the needed extent of substantive procedures

The main way to increase the extent of audit procedures is to examine more items

Sample sizes should reduce detection risk so as to restrict audit risk to a low level


5-19

General on Analytical Procedures(1 of 3)

Timing of analytical procedures Risk assessment (sometimes referred to as

planning analytical procedures) Substantive procedures Final review

Steps involved Develop expectation of account (or ratio) balance Determine amount of difference that can be accepted

without investigation Compare the company’s account (ratio) with the

expectation Investigate and evaluate significant differences


5-20

General on Analytical Procedures

(2 of 3) Developing an expectation

Prior period information Anticipated results Relationships among elements of financial information

within a period Industry information Relationships between financial information and

relevant nonfinancial data.


5-21

General on Analytical Procedures (3 of 3)

Types of Expectations Trend analysis—analyze changes in accounts

of a company over time Ratio analysis — compare relationships

between two or more financial statement accounts or comparisons of account balances to nonfinancial data Liquidity (e.g., current ratio) Leverage (e.g., debt to equity) Profitability (e.g., gross profit percentage) Activity (e.g., inventory turnover)


5-22

Ratio Analysis

Approaches to ratio analysis Horizontal analysis

Review ratios over time Cross sectional analysis

Analyze ratios of similar firms at a point in time Vertical analysis

Analyze relationships within a period “Common size” statements prepared

Other methods Regression analysis, reasonableness test


5-23

Identifying Potential Misstatements

Figure 5.5


5-24

Basic Approaches to Auditing Accounting Estimates

Review and test management’s process for developing the estimate.

Independently develop an estimate to compare to management’s estimate.

Review subsequent events or transactions bearing on the estimate.


5-25

Auditing Fair Values Inputs to use in applying valuation techniques

(FAS 157) Level 1 – inputs of observable quoted prices in

active markets for identical assets or liabilities Ex. A closing stock price in WSJ

Level 2 – inputs of observable quoted prices, generally for similar assets or liabilities in active markets Ex. Company discounts future cash flows on its not

publicly traded debt securities at rate used by market for publicly traded debt securities

Level 3 – inputs that are unobservable for the assets or liability Ex. A private company uses judgment to determine a proper rate to

discount the future cash flows of its not publicly traded securities


5-26

Related Party Transactions

Disclosure requirements must be met Primary challenge is identifying

undisclosed related party transactions Determine related parties

Inquiries of management Review SEC filings, stockholder’s listings and

conflict-of-interest statements Be alert for transactions with related parties

and any transactions with unusual terms


5-27

Functions of Audit Documentation Primary functions:

•Support the auditors’ compliance with auditing standards

•Support the auditors’ opinion Secondary functions:

•Assist continuing and new audit team members in planning and performing the audit

•Serves as a record of matters of continuing audit interest

•Assists in supervision and review of the audit•Demonstrates the accountability of team members

•Assists internal reviewers, external peer reviewers, PCAOB inspectors, and successor auditors in performing their roles


5-28

Sufficiency of Audit Documentation

Audit documentation should be sufficient to: Enable an experienced auditor to understand

the work performed and the significant conclusions reached

Identify who performed and reviewed the work Show that the accounting agree or reconcile to

the financial statements Audit documentation should include all

significant audit findings and the actions taken to address them


5-29

Types of Working Papers

Audit administrative working papers Working trial balance Lead schedules Adjusting journal entries and

reclassification entries Supporting schedules Analysis of a ledger account Reconciliations Computational working papers Corroborating documents


5-30

Types of Working Files

Current files Current year working papers Index and cross-referencing

Permanent files Items of continuing audit

interest


5-31Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Organization of the Current Files Figure 5.7

5-32

Preparation of a Working Paper Figure 5.8


5-1 copyright © 2016 mcgraw-hill education. all rights reserved. no reproduction or distribution...

Documents

financial statements

audit riskthe possibility

material departure

recorded transactions

equity interests

control riskrisk

auditors procedures

classes of transactions