Chapter 6 - Evidence

Question 1

Audit evidence

Answer 1

In order for the auditor’s opinion to be trustworthy, auditors must come to the conclusions having completed a thorough examination of the books and records of their clients.

They must document the procedures performed and evidence obtained to support the conclusions reached.

Sufficiency relates to the quantity of evidence.
Appropriateness relates to the quality or relevance and reliability of evidence.

Question 2

Sufficient evidence

Answer 2

When determining whether there is enough evidence to support the auditor’s conclusion, the auditor must consider:

1. The risk of material misstatement.
2. The materiality of the item.
3. The nature of accounting and internal control systems.
4. The auditor’s knowledge and experience of the business.
5. The results of control tests.
6. The size of a population being tested.
7. The size of the sample selected to test.
8. The reliability of the evidence obtained.

Question 3

Appropriate evidence

Answer 3

Reliability:
Auditors should obtain evidence from the most trustworthy and dependable source possible.
Evidence is most reliable when:-
1. Obtained from an independent external source.
2. Generated internally but subject to effective control.
3. Obtained directly by the auditor.
4. In documentary form.
5. In original form.

Relevance:
Audit evidence has to address the objective/ purpose of a procedure.

e.g.
Select a sample of items from physical inventory and trace them to inventory records to confirm completeness of accounting records.

Select a sample of items from inventory records and trace them to physical inventories to confirm the existence of inventory assets.

Similar in nature but tests different assertions regarding inventory balances.

Question 4

Financial statements assertions

Answer 4

Many ways inventory could be materially misstated.

1. Items missed out on inventory.
2. Items from next accounting period could be accidentally included.
3. Might not be values at lower of cost and NRV.
4. Damaged or obsolete items not identified.
5. Purchase cost may not be recorded accurately.
6. Inventory count may not be performed correctly.

Auditors perform tests on transactions, account balances and disclosures.

Transactions and Events
Occurrence - Transactions and events actually recorded and pertain to the entity.
Completeness - All transactions, assets, liabilities and equity interests have been recorded that should have been recorded.
Accuracy - Amounts, data and other information have been recorded and disclosed appropriately.
Cut-off - Transactions and events have been recorded in the correct accounting period
Classification and understandability - Transactions and events have been recorded in the proper accounts and clearly described and disclosed.
Existence - Assets, liabilities and equity interests exist.
Rights and obligations - The entity holds or controls the rights to assets and liabilities are the obligations of the entity.
Valuation and allocation - Assets, liabilities and equity interests are included in the financial statements at appropriate values.

Question 5

Sources of audit evidence

Answer 5

Tests of control - designed to evaluate the operating effectiveness of controls in preventing or detecting and correcting material misstatement.

Audit risk = Inherent risk x Control risk x Detection risk

Substantive procedures - designed to detect material misstatement at the assertion level.

Question 6

Types of audit procedures

Answer 6

1. Inspection of documents and records - Examining records or documents in paper or electronic form.
   - May give evidence of rights and obligations.
   - May give evidence a control is operating.
   - May give evidence about cut off.
   - Confirm sales values and purchase costs.
2. Inspection of tangible assets - Physical examination of an asset.
   - To obtain evidence of existence.
   - May give evidence of valuation.
3. Observation - Looking at a process or procedure performed by others.
   - May provide evidence a control is being operated.
   - Only provides evidence the control is being operating properly at time of observation. The auditors presence may influence the operation of the control.
   - Observation of a one off event.
4. Enquiry - Seeking information financial and non-financial within the entity or outside.
   - Results need corroborating as responses generated by the audit are considered to be low quality.
   - Written representations from management to confirm oral enquiries.
5. Confirmation - Obtaining a direct response.
   - e.g. Circulation of receivables, payables, confirmation of bank balances in a bank letter, actual/ potential penalties from legal advisors, inventories held by third parties.
   - May give good evidence of existence of balances.
   - May not necessarily give reliable evidence of valuation.
6. Recalculation - Manually or electronically checking the arithmetic accuracy of documents, records, or the clients calculations.
7. Re performance - The auditors independent execution of procedures controls that were originally performed as part of the entity’s internal control system.

Question 7

Sampling

Answer 7

Usually impossible to test every item in an accounting population due to the time and cost involved.

Auditors give reasonable not absolute assurance therefore not certifying the financial statements are 100% accurate.

Audit evidence is gathered on a test basis.

The application of audit procedures to less than 100% of items within a population of audit relevance such that all sampling units have a chance of selection. In order to provide the auditor with a reasonable basis on which to draw conclusions about the entire population.

1. When sampling, the auditor must choose a representative example.
2. If a sample is representative, the same conclusion will be drawn from that sample as would have been drawn had the whole population been tested.
3. For a sample to be representative, it must have the same characteristics as the other items population it was chosen from.

Question 8

Sample selections

Answer 8

1. Random selection
   Achieved through the use of random number generators or tables.
2. Systematic selection
   Where a constant sampling interval is used e.g. Every 50th balance and the first item is selected randomly.
3. Monetary unit selection
   Selecting items based upon monetary values (usually focusing on higher value items).
4. Haphazard selection
   Auditor does not follow a structured technique but avoids bias or predictability.
5. Block selection
   Involves selecting a block of contiguous (next to each other) items from the population. This technique is used for cut-off testing.

Question 9

Stratification

Answer 9

The process of breaking down a population into smaller sub populations with each being a group of items (sampling units) which have similar characteristics.
e.g. The auditor may stratify the population of accounts receivable into two populations: balances > £10000 and balances < £10000. They may test all accounts receivables balances over £10000 and then a representative sample of the items < £10000

The sample size depends on the level f sampling risk that the auditor s willing to accept.

Question 10

Sampling risk

Answer 10

Arises from the possibility the auditor’s conclusion based on a sample may be different from the conclusion that would be reached if the entire population were subjected to the same audit procedure.

Auditors are faced with sampling risk in tests of controls and in substantive procedures. Sampling risk is the risk the auditor’s sample from a population will not be representative.

In order to reduce sampling risk, the auditor needs to increase the size of the sample selected.

Question 11

Computer Assisted Audit Techniques (CAATs)

Test data

Answer 11

1. Test data
   Involves the auditor submitting dummy data into the clients system to ensure the system correctly possesses it to prevents, detects and corrects misstatements.
   The objective is to test the objective of controls within the system.

Successful data should include both data with errors built into it and data without errors. For e.g.

1. Codes that do not exist
2. Transactions above pre determined limits e.g. Salaries above contracted amounts, credit above limits agreed with customer.
3. Invoices with arithmetical errors.
4. Submitting data with incorrect batch control totals.

Data may be processed during a normal operational cycle or during a special run.

• Live tests could Intefere with the operation of the system or corrupt master files.
• Dead testing avoids this issue but only gives assurance that the system works when not operating live.

Question 12

Advantages and disadvantages of test data

Answer 12

Advantages

1. Enables the auditor to test programmed controls
2. Once designed, costs incurred will be minimal unless the programmed controls are changed which requires the test data to be resigned.

Disadvantages

1. Risk of corrupting clients.
2. Require times spent on clients system.

Question 13

Audit software

Answer 13

Used to interrogate a clients system either packaged, off the shelf software or purpose written to elm on a clients system. The main advantage can be used to scrutinise large volumes of data.

Specific procedures they can perform include:
1. Extracting samples according to specified criteria such as
random, over a certain amount, below a certain amount, at certain dates.

2. Calculating ratios and select indicators that fail to meet certain pre defined criteria (benchmarking).
3. Check arithmetical accuracy.
4. Preparing reports (budgets vs actual)
5. Stratification of data (such as invoices by customer or age)
6. Produce letters to send to customers and suppliers.

Question 14

Advantages and disadvantages of audit software

Answer 14

Advantages:

1. Calculations and casting of reports will be quicker.
2. More transactions can be tested with manual testing.
3. The computer files are tested rather than printouts.
4. Once set up, can be cost effective means of testing.

Disadvantages:

1. Bespoke software can be expensive to set up.
2. Training of audit staff will be required incurring additional cost.
3. The audit software may slow down or corrupt the clients systems.
4. If errors are made in the software design, issues may go undetected by the auditor.

Question 15

General advantages and disadvantages of CAATs

Answer 15

Advantages:

1. Enables the auditor to test more items more quickly.
2. The auditor is able to test the system rather than printouts.
3. Obtain greater evidence as CAATs can be compared with other tests to increase audit confidence.
4. Perform audit tests more cost effectively.

Disadvantages:

1. CAATs can be expensive and time consuming to set up.
2. Client permission and cooperation may be difficult to obtain.
3. Potential incompatibility with the clients computer system.
4. The audit team may not have sufficient IT skills and knowledge to create complex data extracts and programming required.
5. The audit team may not have knowledge or training needed to understand results of CAATs.
6. Data may be corrupted or lost during the application of CAATs.

Question 16

Auditor’s expert

Answer 16

1. Competence, capability and objectivity.
   The external auditor must asses the expert before performing work.
2. Agreeing the work to be performed.
   The auditor should agree in an engagement letter with the expert before any work is performed.
   - The nature, scope and objectives of the expert’s work.
   - The roles and responsibilities of the auditor and the expert.
   - The nature, timing and extent of communication between the two parties.
   - The need for the expert to observe confidentiality.
3. Evaluating the work.
   Once work is completed, the auditor must assess it to ensure it is appropriate for the purpose of the audit.
   - The consistency of the findings with other evidence
   - The relevance and reasonableness of the assumptions and methods used by the expert.
   - The relevance, completeness and accuracy of the source data used.

If work is not deemed accurate, further work must be agreed with the expert.

4. Relying on internal audit.
   If internal audit is an effective control system, it reduces control risk, and reduces the need for auditors to perform detailed substantive testing.
   Auditors may be able to co-operate with a client’s internal audit department and place reliance on their procedures.
   For example: Tests of controls, risk assessment, fraud investigations, compliance with laws and regulations.
5. Evaluating the internal audit function.
   The extent to which the internal audit function’s organisational status and relevant policies and procedures support the objectivity of the internal auditors.
   The competence of the internal audit function.
   Whether internal audit applies a systematic and disciplined approach including quality control.
6. Evaluating the internal audit work.
   To plan adequate time to review the work of internal audit function to evaluate whether,
   - Work was properly planned, performed, supervised, reviewed and documented.
   - Sufficient appropriate evidence has been obtained.
   - The conclusions reached are appropriate in the circumstances.
   - The reports are consistent with the work performed.
7. Using internal audit to provide direct assistance.
   For audits of FS with a year ending on or after 15 December 2014, external auditors consider if the internal auditor can provide direct assistance with gathering audit evidence under the supervision and review of the external auditor.

Direct assistance cannot be provided where laws and regulations prohibit such assistance.

The competence and objectivity of the internal auditor ( threats to objectivity and significance to manage to an acceptable level).

The external auditor must not assign work to the internal auditor which involves significant judgement, a high risk of material misstatement or which the internal auditor has been involved.

The planned work must be communicated with those charged with governance.

Where it is agreed the internal auditor can provide direct assistance:

• Management must agree in writing the in internal auditor can provide such assistance and that they will not intervene in that work.
• The internal auditors must provide written confirmation that they will keep the external auditors information confidential.
• The external auditor will provide direction, supervising and review of the internal auditors work.
• The external auditor should remain alert to the risk the internal auditor is not objective or competent.

8. Documentation.
   The auditor should document:
   - The evaluation of the internal auditor’s objectivity and competence.
   - The basis for the nature and extent of the work performed by the internal auditor.
   - The name of the reviewer and extent of the review of internal auditor’s work.
   - The written agreement of management.
   - The working paper produced by the internal auditor.

Examples of work the internal audit function that can be used by the external auditor include.

• Testing of the effectiveness of controls.
• Substantive procedures involving limited judgement.
• Observations of inventory counts.
• Tracing transactions through he information system to financial reporting.
• Testing compliance with regulatory requirements.

Th external auditor is not required to rely on the work of internal audit. In some cases, external auditor may be prohibited by law.