Auditing Theory
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Chap005_21e_Final.pptxChapter 05
Audit Evidence and
Documentation
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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.
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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)
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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 |
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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, while liabilities 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
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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.
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Audit Risk Formula
AR = IR * CR * DR
AR = Audit risk
IR = Inherent risk
CR = Control risk
DR = Detection risk
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Audit Risk Figure 5.2
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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 the accounting department
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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
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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
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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
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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
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Types of Audit Procedures
Inspection of records and documents
Inquiry of knowledgeable persons within or outside the entity
External confirmation
Inspection of tangible assets
Observation of processes or procedures being performed by others
Recalculation of mathematical accuracy
Reperformance of procedures
Analytical procedures
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Audit Procedures and Examples Figure 5.3
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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)
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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.
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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
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General on Analytical Procedures 1/3
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
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General on Analytical Procedures 2/3
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
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General on Analytical Procedures 3/3
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)
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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
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Identifying Potential Misstatements
Figure 5.5
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Illustration 1 of Effects of Journal Entries on Ratios
December 31 credit sale (real or fraudulent)
Ratio of Sales to AR shortly before year-end:
$700,000 / $100,000 = 7.00
Recording a $50,000 credit sale on 12/31
($700,000 + $50,000) / ($100,000 + $50,000)
$750,000 / $150,000 = 5.00
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Illustration 2 of Effects of Journal Entries on Ratios
December 31 cash sale (real or fraudulent)
Ratio of Sales to AR shortly before year-end:
$700,000 / $100,000 = 7.00
Recording a $50,000 cash sale on 12/31
($700,000 + $50,000) / ($100,000)
$750,000 / $150,000 = 7.50
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Effects of changes in numerators and denominators of ratios greater than zero
Increasing the numerator of a ratio always increases the ratio.
Increasing the denominator of a ratio always decreases the ratio.
Increasing the numerator and denominator of a ratio by the same amount:
Decreases the ratio if the ratio is greater than 1.
Increases the ratio if the ratio is less than 1.
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Data Analytics
Data analytics is the process of using related and unrelated data sets to provide insights into decisions.
CPA firms are increasing using data analytic approaches to improve risk assessment, tests of controls and substantive procedures.
In risk assessment, sophisticated data analytics can improve auditors’ assessments of risk by significantly increasing the sources of data used.
In tests of controls, data analytics may allow the auditors to use technology to test 100 percent of the items in a population by relating data from multiple sources
Substantive procedures may be improved by using data from a number of data sources to improve the efficiency and effectiveness of the procedures.
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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.
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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 estimated future cash flows of its not publicly traded securities
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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
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Functions of Audit Documentation
Primary functions:
Support the auditors’ compliance with auditing standards
Support the auditors’ opinion
Secondary functions:
Assists 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
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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
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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
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Types of Working Files
Current files
Current year working papers
Index and cross-referencing
Permanent files
Items of continuing audit interest
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Organization of the Current Files Figure 5.7
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Preparation of a Working Paper Figure 5.8
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