UNIT 5: AUDIT EVIDENCE

Contents
5.0 Aims and Objectives
5.1 Introduction
5.2 Audit Evidence
5.2.1 Sufficient Appropriate Audit Evidence
5.2.1.1 Sufficiency of Audit Evidence
5.2.1.2 Reliability of Evidence
5.2.2 Procedures for Obtaining Audit Evidence
5.2.3 Evidence About Accounting Estimates
5.3 Documenting the Audit Process
5.3.1 Form and Content of Working Papers
5.3.2 Examples of Working Papers
5.3.3 Confidentiality, Safe Custody and Ownership
5.4 Summary
5.5 Answer to Check Your Progress Exercise

5.0 AIMS AND OBJECTIVES

After studying this unit, you should be able to:

- distinguish between the concepts of competence and sufficiency as they apply to audit
evidence
- describe the type of procedures used to obtain audit evidence
- list and describe the various types of evidence
- describe the auditors' approach to auditing accounting estimates
- describe the functions of audit working papers
- discuss the factors that affect the auditors judgment as to the quantity, type and content
of the working papers.

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5.1 INTRODUCTION

Before we can start the audit, we must determine what kind of evidence we are looking for:
particularly what kind of evidence would satisfy an auditor and what kinds would not. In the
exam you might be asked to make judgments on the strength of particular types of evidence.

We also introduce the financial statement assertions. These will be particularly important
when we consider balance sheet testing, since the balance sheet tests are designed to obtain
sufficient evidence about the assertions in each area.

We will then look at how audit evidence is documented and the kind of working papers which
should be kept on file.

5.2 AUDIT EVIDENCE

Audit evidence is the information auditors obtain in arriving at the conclusion on which their
report is based. Audit evidence comprises source documents and accounting records
underlying the financial statement assertions and corroborative evidence from other sources.

Auditors should obtain sufficient appropriate audit evidence to be able to draw reasonable
conclusions on which to base the audit opinion.

Audit evidence can be obtained in many ways, often with a mix of tests of controls and
substantive procedures, although sometimes only substantive procedures will be used along
with requires as to the adequacy of the accounting system as a basis for the preparation of the
financial statements.

5.2.1 Sufficient Appropriate audit evidence

'Sufficiency and appropriateness' are interrelated and apply to both tests of controls and
substantive procedures.
a) Sufficiency is the measure of the quantity of audit evidence.
b) Appropriateness is the measure of quality or reliability of the audit evidence.

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Auditors are essentially looking for enough reliable audit evidence. Audit evidence usually
indicates what is probable rather than what is definite (is usually persuasive rather than
conclusive) so different sources are examined by the auditors. However, auditors cannot give
absolute but only reasonable assurance that the financial statements are free from
misstatement, so not all sources of evidence be examined.

5.2.1.1 Sufficiency of Audit Evidence

The auditors judgment as to what is sufficient appropriate and evidence is influenced by
factors such as the following.
a) The assessment of the nature and degree of risk of misstatement at both the financial
statement level and the account balance or class of transactions level.
b) The nature of the accounting and internal control system, including the control
environment.
c) The materiality of the item being examined.
d) The experience gained during previous audit and the auditors' knowledge of the
business and industry.
e) The results of audit procedures, and from any audit works carried out in the course of
preparing the financial statements, including indications of fraud or error.
f) The source and reliability of information available.

If they are unable to obtain sufficient appropriate audit evidence, the auditors should consider
the implications for their report.

Tests of Control
In seeking to obtain audit evidence from tests of control, auditors should consider the
sufficiency and appropriateness of the audit evidence to support the assessed level of controls
risk.

There are two aspects of the relevant parts of the accounting and internal control systems
about which auditor should seek to obtain audit evidence.

a) Design: the accounting and internal control systems are capable of preventing or
detecting material misstatements.

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 b) Operation: The system exists and have operated effectively throughout the relevant
period.

Substantive Procedures
In seeking to obtain audit evidence from substantive procedures, auditors should consider the
extent to which that evidence together with any evidence from test of control supports the
relevant financial statement assertions.

Substantive procedures are designed to support the financial statement assertions.

Financial statement assertions are the representations of the directors that are embodied in the
financial statements. By approving the financial statements, the directors are making
representations about the information therein. These representatives or assertions may be
described in general terms in a number of ways, one of which is as follows.

- Existence: an asset or liability exists at a given date

- Right and obligations: an asset or liability pertains to the entity at a given date
- Occurrence: a transaction or event took place which pertains to the entity during the
relevant period
- Completeness: there are no unrecorded assets, liabilities, transactions or events or
undisclosed items
- Valuation: an asset or liability is recorded at an appropriate value.
- Measurement: a transaction or even is recorded in the proper amount and revenue or
expense is allocated to the proper period.
- Presentation and disclosure: an item is disclosed, classified and described in
accordance with the applicable reporting framework. (eg. Relevant legislation and
applicable accounting standards).
- Audit evidence: is usually obtained to support each financial statement assertion and
evidence from one does not compensate for failure to obtain evidence for another.
However, tests may provide audit evidence of more than one assertion.
- Where tests of control provide satisfactory evidence as to the effectiveness of
accounting and internal control system, the extent of relevant substantive procedures

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 may be reduced, but not entirely eliminated. Substantive procedures may also be
incorporated within other procedures such as test of control.

5.2.1.2 Reliability of Evidence

The reliability of audit evidence is influenced by its source (internal or external) and by its
nature (visual, documentary or oral). The following generations may help in assessing that
reliability.

a) Audit evidence from external sources (e.g., confirmation received from a third party)
is more reliable than that obtained from the entity's records.
b) Audit evidence obtained from the entity's records is more reliable when the related
accounting and internal control system operates effectively.'
c) Evidence obtained directly by auditors is more reliable than that obtained by or from
the entity.
d) Evidence in the form of documents and written representations is more reliable than
oral representations.
e) Original documents are more reliable than photocopies, telexes or facsimiles.

Consistency of audit evidence from different sources will have a corroborating effect, making
the evidence more persuasive. Where such evidence is inconsistent, the auditors must
determine what additional procedures are necessary to resolve the inconsistency.

Auditors must consider the cost-benefit relationship of obtaining evidence but any difficulty
or expense is not in self a valid basis for omitting a necessary procedure.

5.2.2 Procedures of Obtaining Audit Evidence

Auditors obtain evidence by one or more of the following procedures.
a) Inspection
b) Observation
c) Enquire and confirmation
d) Computation
e) Analytical procedures

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a) Inspection
Inspection of records and documents involves inspecting documents, which demonstrate
that a transactions has occurred or is valid, or a balance exists. It may also involve
comparing documents to see that the information contained in both is consistent.

Inspection is an important test of control in that it can be used to test whether documents
such as invoices have been properly authorized. It can also highlight whether a transaction
in the accounting records does not relate to the client, for example a transaction supported
by an invoices which is not addressed to the client.

The reliability of audit evidences obtained by inspection of records and documents varies
according to the nature/source and effectiveness of internal control over their processing.

Three major categories of documentary evidence exist, given here in descending degrees
of reliability as audit evidence.
i) created and provided to auditors by third parties
ii) created by third parties and held by the entity
iii) created and held by the entity

Inspecting of tangible assets provides reliable audit evidence about their existence but not
necessary as to their ownership or value. (The assets' appearance may indicate they are
obsolete, but more work will be required to confirm exact valuation).

b) Observation
Observation involves looking at a procedure being performed. Examples of observation
are attendance at the stock taker or at the opening of post.

In some ways observation gives limited assurance since it only provides evidence of how
the procedure was performed when the auditor was watching client staff may have been
on their best behavior on that occasion and be less conscientious of other items.

c) Enquires and Confirmation

Enquiries involve seeking information from the client's staff or external sources. Enquiries
may range from formal written ones to third parties to oral ones to person inside the entity
response may provide auditors with.

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 i) information not previously possessed; or
ii) corroborative audit evidence

The strength of the evidence depends on the knowledge and integrity of the source.

Confirmation aim to verity what is shown in the client's accounting records. Examples of
confirmations include direct confirmation of debts by debtors of the clients or bank
balances by the entity's bank.

d) Computation
Computations involve the auditor checking the arithmetic of the client's records or
carrying out other relevant calculations. Examples of computations include the adding up
of bank reconciliation or ledger accounts.

e) Analytical Procedures
Analytical procedures are the analysis of relationships.
i) between items of financial data, or between items of financial and non-financial
data, deriving from the same period; or
ii) between comparable information deriving from different periods to identify
consistencies and predicted patterns or significant fluctuations and unexpected
relationships, and the results of investigation thereof.

5.2.3 Evidence About Accounting Estimates

The auditors must be especially careful in considering financial statement accounts that are
affected by estimates made by management (often referred to an accounting estimates)
particularly those for which a wide range of accounting methods are considered acceptable.
Examples of accounting estimates include allowances for loan losses and obsolete inventory,
and estimates of warranty liabilities. Making accounting estimates is management's
responsibility, and such estimates are generally more susceptible to material misstatement
than financial statement amounts, which are more certain in amount. Standard of auditing
requires the auditors to determine that
a) all necessary estimates have been developed
b) the accounting estimates are reasonable, and
c) the accounting estimates are properly accounted for and disclosed.

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Determining whether all necessary estimates have been developed and accounted for properly
requires a knowledge of the client's business and the applicable generally accepted accounting
principles. When evaluating the reasonableness of accounting estimates, the auditors may use
one or more of the following three basic approaches:
1. Reviewing and testing management's process of developing the
estimates – this will often involve evaluating the reasonableness of the steps performed
by management.
2. Independently developing an estimate of the amount to compare to
management's estimate.
3. Reviewing subsequent events or transactions bearing on the estimate,
such as actual payments of an estimated amount made subsequent to year-end.

5.3 DOCUMENTING THE AUDIT PROCESS

All audit work must be documented; the working papers are the tangible evidence of the work
done in support of the audit opinion. Auditor should document in their working papers
matters, which are important in supporting their report.

Working papers are the material the auditors prepare or obtain, and retain in connection with
the performance of the audit. Working papers may be in the form of data stored on paper,
firm, electronic media or other media.

Working papers support, amongst other things, the statement in the auditors' report as to the
auditors' compliance or otherwise with auditing standards to the extent that this is important in
supporting their report.

Working papers are a record of

a) the planning and performance of the audit
b) the supervision and review of the audit work; and
c) the audit evidence resulting from the audit work performed which the auditors
consider necessary and on which they have relied to support their report.

5.3.1 Form and Content of Working Papers

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Working papers should record the auditors' planning, the nature, timing, and extent of the
audit procedures performed, and the conclusions drawn from the audit evidence obtained.
Auditors should record in their working papers their reasoning on all significant matters,
which require the exercise of judgment, and their conclusions thereon.

Auditors cannot record everything they consider. Therefore judgment must be used as to the
extent of working papers, based on what would be necessary to provide an experienced
auditor, with no previous connection with the audit, with an understanding of the work
performed and the basis of the decision taken.

Difficult areas of judgment or questions of principle may be questioned by a third party with
the benefit of hindsight in such circumstances it is important to be able to demonstrate the
relevant facts were known at the time the auditors reached their conclusion.

The form and content of working papers are affected by matters such as:
a) the nature of engagement
b) the form of the auditors' report
c) the nature of complexity of the entity's business
d) the nature and condition of the entity's accounting and internal control system
e) the needs in the particular circumstances for direction, supervision and review of the
work of members of the audit team, and
f) the specific methodology and technology the auditors use.

The accounting standard warns on the use of standardized working papers, eg. Checklists,
specimen letters, they may improve the efficiency with which such working papers are
prepared and reviewed. While they facilitate the delegation of work and provide a means to
control its quality, it is never appropriate to follow mechanically a standard approach to the
conduct and documentation of the audit without regard to the need to exercise professional
judgment.

While auditors utilize schedules, analyses etc prepared by the entity, they require evidence
that such information is properly prepared.

5.3.2 Examples of Working Papers

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These include the following.
- information concerning the legal and organizational structure of the client
- extracts or copies of important legal documents, agreements and minutes
- information concerning the client's industry, economic and legal environment
- evidence of the planning process and any changes thereto
- evidence of the auditors' understanding of the accounting and internal control system
- evidence of inherent and control risk assessment and any revisions
- evidence of the auditors' consideration of the work of internal audit
- analysis of significant ratios and trends
- analysis of transactions and balances
- a record of the nature, timing, extent, and results of auditing procedures
- details of confirmation procedures on work carried out by other auditors
- copies of communications with other auditors, experts and other third parties
- copies of correspondence with the client, reports to directors or management and notes
of discussions with the entity's directors or management concerning audit matters
- letters of representation from the entity's directors or management
- a summary of the significant aspects of the audit including details of the information
available, the amount involved, management's views, the conclusions reached and
how these matters are resolved or treated
- copies of the approved financial statements and auditor's reports.

Working papers should show:

- the name of the client
- the balance sheet date
- the fire reference of the working paper
- the name of the person preparing the working paper
- the date of the working paper was prepared
- the subject of the working paper
- the name of the person reviewing the working paper
- the date of the review

Working papers should also show:

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 - the objective of the work done
- the source of information
- how any sample was selected and the sample size determined
- the work done
- a key to any audit ticks or symbols
- the results obtained
- analysis of errors or other significant observations
- the conclusions drawn
- the key points highlighted

For recurring audits, working papers may be split between:

a) permanent audit files: updated with new information of continuing importance; and
b) current audit files: contain information relating primarily to the audit of a single
period.

5.3.3 Confidentiality, Safe Custody and Ownership

Auditors should adopt appropriate procedures for maintaining the confidentiality and safe
custody of their working papers.

Statute does not set down the period of retention of audit working papers; judgment must be
used; and further consideration should be given to the matter before their destruction.

Working papers are the property of the auditors. They are not a substitute for, not part, of the
entity's accounting records.

Auditors must follow ethical guidance on the confidentiality of audit working papers. They
may, at their discretion, release parts of or whole working papers to the entity, as long as
disclosure does not undermine the independence or validity of the audit process. Information
should not be made available to third parties without the permission of the entity.

Check Your Progress Exercise

1. Define 'sufficiency and appropriateness' in relation to audit evidence.

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2. What generalizations are made in relation to the sources and nature of audit
evidence?
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3. What are the main procedures for obtaining audit evidence?
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4. What major aspects should the audit working papers record?
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5. What matters affect the form and content of working papers?
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6. What details should audit working papers show?
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5.4 SUMMARY

The auditors must be able to evaluate all types of audit evidence in terms of its sufficiency
and appropriateness. Evidence can be in the form of tests of controls or substantive
procedures.

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Tests of controls concentrate on the design and operation of controls. Substantive testing aims
to test all the financial statement assertions.
- Existence
- Rights and obligations (ownership)
- Occurrence
- Completeness
- Valuation
- Measurement
- Presentation and disclosure

The reliability of audit evidence is influenced by its source and by its nature. Audit evidence
can be obtained by the following techniques.
- Inspection
- Observation
- Enquiry and confirmation
- Computation
- Analytical procedures

The proper completion of working papers is fundamental to the recording of the audit. They
should show when and by whom the work was performed and reviewed.

5.5 ANSWER TO CHECK YOUR PROGRESS EXERCISE

7. Refer Section 5.2.1

8. Refer Section 5.2.1.2
9. Refer Section 5.2.2
10. Refer Section 5.3
11. Refer Section 5.3.1
12. Refer Section 5.3.2

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