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chapter 5 audit evidence and documentation in performing financial statement audits the auditors gather and evaluate audit evidence to form an opinion about whether the financial statements follow the appropriate criteria usually generally accepted audit accounting principles there is always a possibility called audit risk that the auditors will issue an unmodified opinion on financial statements that contain a material departure from gaap in order to lessen this risk to an acceptably low level the auditor should obtain sufficient appropriate audit evidence the quantity of audit evidence needed is affected by both the risk of misstatement the greater the risk the greater the audit evidence and the quality of the evidence the lower the quality the more evidence is required when management prepares the financial statements in conformity with the applicable financial reporting framework certain assertions are made about the various accounts transactions and disclosures not every assertion applies to every account transaction or disclosure and the assertions may be viewed as implicitly or explicitly stated the auditor tests the relevant assertions made to determine if the financial statements were prepared in ance with the applicable financial reporting framework this chart shows the financial statement assertions that the auditing standards board in the international standards have identified as being relevant to the accounts transactions and disclosures all assertions do not apply to every account transaction or disclosure in every category at all times for example the existence and completeness assertions may always be relevant to the cash account but valuation is not unless currency translation is involved in designing audit procedures the auditors may use the assertions considered relevant in a condensed set provided that all financial statement aspects of generally accepted accounting principles are covered in other words auditors may combine or summarize the assertions consistent with this approach the text combines some assertions as are shown in this slide these assertions will be discussed in greater detail in chapter 6 and are used throughout the course financial statement assertions are important to auditors because they should consider audit risk at the assertion level for all significant account balances transaction classes and disclosures audit risks consist of two components first is the risk of material misstatement of a relevant assertion related to an account balance class of transaction or disclosure second is the risk that the auditors will not detect such misstatement also known as detection risk the risk of material misstatement is made up of two components inherent risk and control risk inherent risk is the possibility of material misstatement of an assertion before consideration of the client's internal controls control risk is the risk that a material misstatement could occur in a relevant assertion and not be prevented or detected on a timely basis by the client's internal controls detection risk is the only risk that the auditor can control and is the risk that the auditor's procedures will lead them to believe that a material misstatement does not exist when in fact one does the audit risk formula helps to illustrate audit risk ar stands for audit risk ir for inherent risk cr for control risk and dr for detection risk as we see audit risks may be quantified auditing standards allow either a quantitative or non-quantitative approach in measuring audit risk we can see by this formula that the overall audit risk is a function of the risk of each of the components and by assessing each of the components the auditor can determine the overall audit risk it is important to realize that the model expresses general relationships and is not necessarily intended to be a mathematical model to precisely consider the factors that influence audit risk in actual audit situations this diagram illustrates the risk of the audit at the top of the figure we see the risk of material misstatement which is a function of the inherent risk and control risk of the individual client the inherent risk and control risk cannot be controlled by the auditor the inherent risk shown by the bag of sand is the risk that misstatements are likely to occur in the client's financial statements this sand is then filtered through the client's internal control system the inter the control risk is the risk that the client's internal controls will not prevent or detect the misstatements those misstatements will continue on and can only be detected by the auditor the sand is then filtered through the auditor's procedures at the very end of the diagram we see that there is still some sand left which is the risk that misstatements will even go undetected by the auditors however this risk should be at an acceptably low level after the audit is completed inherent risk relates to either the nature of the client and its environment or the nature of the particular financial statement element business characteristics of the client in its environment that are indicative of high inherent risk can include inconsistent profitability of the client as compared to other firms in the industry operating results that are highly sensitive to economic factors going concern problems large known and likely misstatements detected in prior audits and substantial turnover questionable reputation or inadequate accounting skills of management these factors are also important in evaluating whether to even accept an engagement for audit inherent risk also varies by the nature of the account some assertions themselves are associated with high inherent risk and involve difficult to audit transactions or balances complex calculations difficult accounting issue significant judgment by management and valuations that vary significantly based on economic factors in assessing inherent risk it is often useful to segregate transactions into three types routine non-routine and estimation routine transactions involve recurring financial statement activities recorded in the accounting records in the normal course of business examples include sales purchases cash disbursements etc these transactions have a low inherent risk non-routine transactions involve activities that occur only periodically such as the taking of physical inventories calculating depreciation expense etc inherent risk may be high for non-recurring transactions because they are not part of the normal flow of transactions and may require specialized skills to perform them correctly estimation transactions are the activities that create accounting estimates these activities have high inherent risk because they involve management judgments or assumptions the preceding types of transactions are ordinarily recorded through journal entries in the accounting records company accountants often use top side entries when preparing financial statements top side entries generally are not posted within the client's journals and general ledger but are ordinarily made directly to a spreadsheet or similar schedule being used in the financial statement preparation process these entries may relate to routine non-routine or estimation transactions examples include consolidation entries aggregation or disaggregation of certain accounts such as combining the cash accounts while each of the examples may be appropriate other top side entries may not be for example a fraudulent top side entry might increase earnings by recording a fictitious sale auditors need to be aware of and understand top side entries because such entries present the possibility of misstatement audit evidence is all the information used by the auditors in arriving at the conclusion on which the audit opinion is based it includes the information contained in the accounting records underlying the financial statements and other information audit evidence most must be both sufficient and appropriate sufficiency is a measure of the quantity of audit evidence obtained quantity needed is affected by the risk of material misstatement and the reliability of the evidence appropriateness is the measure of the quality of the audit evidence relevance relates to the assertion being addressed reliability of evidence is dependent on the circumstances in which the evidence is obtained evidence is ordinarily more reliable when it is obtained from knowledgeable independent sources outside the client company generated internally through a system of effective internal controls obtained directly by the auditors rather than indirectly by inference documented in form whether paper or electronic rather than oral and provided by original documents rather than photocopies or facsimiles sufficiency relates to the quantity of appropriate audit evidence required to appropriately restrict audit risk the mix of types and amounts of audit evidence needed is affected by the risk of material misstatement the higher the risk the stronger the audit evidence needed to persuade the auditors and the quality of the total evidence often the auditors find it necessary to rely on evidence that is persuasive rather than conclusive auditors are seldom convinced beyond all doubt that all aspects of the statements are properly stated as we discussed previously in chapter 2 professional skepticism involves maintaining a questioning mind and being alert to conditions that indicate possible misstatements due to fraud or error and critically assessing audit evidence auditors must consider the susceptibility of information to management bias and also unconscious or conscious bias with with which the auditors themselves may be susceptible to in their own evaluation of audit evidence auditors should be aware that a long history of psychological research has shown that human judgments including those of auditors are vulnerable to limitations which may result in insufficient skepticism and biased decisions this slide illustrates some examples of these cognitive biases that auditors may be susceptible to it is important to realize that these biases are not independent of one another auditors may make an error in judgment because of one or more of the biases while not being a complete solution being aware of such biases may improve the auditor's application of professional skepticism risk assessment procedures are designated to obtain an understanding of the client and its environment including its internal controls to assess the risk of material misstatements tests of controls are designed to test the operating effectiveness of controls in preventing or detecting material misstatements and substantive procedures are designed to to detect material misstatements of relevant assertions substantive procedures include analytical procedures and tests of details of account balances transactions and disclosures the auditors perform a variety of audit procedures to obtain audit evidence this slide lists many types of audit procedures perhaps the most widely used procedure is inspection of records and documents auditors evaluate documentation evidence for reliability in the event that documents are forged are created in their entirety by a dishonest employee generally documentary evidence created outside the client organization and transmitted directly to the auditor is more reliable inquiry of knowledgeable persons and representation letters are also important procedures that auditors will use in a variety of circumstances specialists are used when it is necessary for the auditors to consult with experts as a means of gathering evidence external confirmation of accounts such as cash and accounts receivable and inspection of tangible assets are widely used sometimes auditors will just observe a process or procedure and many times will recalculate and re-perform procedures of the client to verify amounts last auditor uses a variety of analytical procedures throughout the audit this slide lists the audit procedures and definitions as well as examples of how the procedures are used during the audit of various accounts transactions and disclosures these audit procedures will be discussed in more detail throughout the text in relation to the audit of relevant assertions of the accounts transactions and disclosures studied substantive procedures include analytical procedures and tests of details these tests are part of the auditor's further audit procedures because their nature timing and extent are based on the results of the risk assessment procedures analytical procedures are based on data interrelationships and consists mostly of comparisons of financial information but also non-financial data tests of details include tests of account balances classes of transactions and disclosures one may change the scope of audit procedures by changing their nature timing and extent nature refers to the type and form of evidence timing refers to when procedures are performed and extent refers to the quantity of evidence obtained holding the extent of audit procedures constant the auditor may increase the scope of procedures making them more effective by obtaining more reliable evidence often that which is externally generated and timing the audit procedures closer to year end to obtain evidence from the entire set of transactions as compared to performing interim testing prior to year end and then updating the procedures for example if the auditors want to increase the assurance obtained related to the existence of accounts receivable they could decide to directly test the ending balance by confirming the accounts rather than relying upon the inspection of internal documents 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 audits do involve the use of sampling procedures but sample size should reduce detection risk so as to restrict audit risk to a low level audits are to be efficient but they must also be effective the auditing standards require that analytical procedures are to be used in the risk assessment stage sometimes referred to as the planning stage and in the final review of the audit the auditors also may decide to use them during the audit as substantive procedures to provide evidence of reasonableness of the specific account balances the steps involved in performing analytical procedures consist of four steps develop an expectation of an account or ratio balance determine the amount of difference from the expectation that can be accepted without investigation compare the company's account or ratio balance with the expectation and investigate and evaluate significant differences from the expectation a variety of types of information are available to auditors to develop expectations for analytical procedures including financial information from prior periods anticipated results such as budgets and forecasts relationships among elements of financial information within a period industry averages and relationships between financial information and relevant non-financial data auditors develop expectations using a number of different techniques trend analysis involves the review of changes in an account balance over time an example would be to review the client's sales for the past three years revealing a consistent growth rate of about seven percent which would assist the auditors in developing an expectation for sales in the current year ratio analysis involves comparisons of relationships between two or more financial statement accounts or comparisons of account balances to non-financial data traditional financial ratios such as liquidity leverage profitability and activity ratios can be used to develop expectations there are basic approaches to ratio analysis horizontal analysis reviews ratios over time and cross-sectional analysis involves comparison with similar firms at a point in time often comparing the client's ratios to industry averages the development of common size financial statements is also known as vertical analysis and analyzes relationships within the same period other methods that may be used include regression analysis which involves the use of statistical models to quantify the auditor's expectation about a financial statement amount or ratio for example the auditor could develop an expectation about the client's sales for this year with a model that uses the amount spent on advertising the square footage of selling space and personal personal disposable income a reasonableness test is similar to regression analysis in that an explicit expectation is computed for a financial statement amount using financial or non-financial data this chart lists examples of analytical procedures that can be performed and how they can be used to identify possible misstatements and accounts and transactions it is important to note that auditors must be careful in making comparisons of ratios between years because journal entries can sometimes have a less than obvious effect on ratios understanding the effects of entries on ratios can help the auditor in their investigation of the underlying cause of increases or decreases it is important to realize that journal entries made at year end may affect ratios calculated prior to year-end for example a change in the accounts receivable turnover may be due to a chart change in credit sales accounts receivable are both given that credit sales are recorded with a debit to accounts receivable and a credit to sales a credit sale recorded near year end will affect both the numerator and the denominator when that receivable remains unpaid at year end if the original accounts receivable ratio near year-end was 7 as shown above and a 50 000 credit sale was recorded on december 31st the accounts receivable ratio to sales would drop to five therefore a recorded credit sale at year end is a possible explanation for a decrease in the accounts receivable turnover however if a cash sale of 50 000 was recorded at year end after the sales to accounts receivable ratio was computed at 7 the effect would only be in the numerator to increase sales and the ratio would increase to 7.5 as shown on this slide the effects on the numerators and denominators and ratios greater than 0 are shown on this slide and can be helpful in assessing the effects of transactions at year end on ratios data analytics are used in businesses and they may be viewed as the examination of large data sets to uncover hidden patterns unknown correlations market trends customer preferences and other useful business information analytical procedures as traditionally performed by auditors may be viewed as a basic form of data analytics data analytical approaches may be very useful in the performance of risk assessment as they will allow the auditor to identify unusual relationships and trends that may be indicative of significant business or audit risk in the area of test of controls data analytics may allow for the testing of all of the transactions in the population rather than a sample data analytics can also improve the effectiveness and efficiency of the auditor substantive procedures for example in a particular high risk form of sale by allowing a detailed analysis of sales data related warranty work and returns and allowances data auditors should be especially careful in considering financial statement accounts that are affected by estimates made by management particularly those for which a wide range of accounting methods are considered acceptable first the auditor determines whether all necessary estimates have been developed and accounted for properly then the auditor determines the reasonableness of accounting estimates by obtaining an understanding of how management developed the estimates and using one or more of these three basic approaches review and test management's process of developing the estimates which often involves evaluating the reasonableness of the steps performed by management independently develop an estimate to compare to management's estimate and review subsequent events or transactions bearing on the estimate such as actual payments of an estimated amount made subsequent to year end in recent years changes in accounting standards have required companies to significantly increase the use of fair values for measuring presenting and disclosing various assets liabilities and components of equity fair value is defined to be the price that would be received to sell an asset or the amount that must be paid to transfer a liability in an orderly transaction between market participants at the measurement date in ance with fas 157 clients must select inputs to use in applying valuation techniques the three levels of inputs are level one observed quoted prices and active markets for identical assets or liabilities such as the closing stock price in the wall street journal level two other observable quoted prices generally for similar assets or liabilities in active markets such as when a company will discount the future cash flows of its not publicly traded debt securities at the rate used by the market for its publicly traded securities and level three which are unobservable inputs for assets or liabilities such as when a private company uses judgment to determine a proper rate to discount the future cash flows of its not publicly traded securities the term related party refers to individuals or entities who may have dealings with the client in which one party is significantly influenced by the other such that it may not pursue its separate interest disclosure of related party transactions should include the nature of the relationships a description of the transactions including dollar amounts and amounts due and from related parties together with the terms and manner of settlement the primary challenge for the auditors in identifying any related party transactions that management has not disclosed common methods of determining related parties include making inquiries of management reviewing sec filings stockholder listings and conflict of interest statements obtained by the client from its executives a list of related parties should be prepared at the beginning of the audit so that audit team members can be alert for transactions with these parties as well as for any transactions with unusual terms that might be indicative of related party transactions audit documentation also known as working papers or work papers is the record of the audit procedures performed relevant audit evidence obtained and the conclusions the auditors reach the primary purpose of the documentation is to support the auditor's compliance with auditing standards and the auditor's opinion secondary functions include assisting both continuing audit team members and auditors new to the engagement in planning and performing the audit assisting audit team members responsible for supervision in reviewing the quality of work performed demonstrating the accountability of team members for the work performed and assisting in internal firm quality control reviews inspections or peer reviews and successor auditors in performing their respective roles audit documentation should be sufficient to enable an experienced auditor to understand the work performed and the significant conclusions reached the audit working paper should also demonstrate that the accounting records agree are reconciled to the financial statements being audited significant audit findings and actions taken to address them should be included such as any test results that indicate the financial statements may be materially misstated any significant difficulties encountered in applying audit procedures proposed audit adjustments and findings that could result in a modification of the audit report finally audit documentation should identify those who performed and reviewed the work and the related dates of performances this is a list of the common types of working papers included in an audit there are general categories into which most working papers are grouped audited administrative working papers working trial balance and lead schedules adjusting entries and reclassification entries supporting schedules analysis reconciliations and computational working papers and corroborating documents the auditors usually maintain two files of working papers for each client a current file and a permanent file the current files for every completed audit and a permanent file of relatively unchanging data the auditor's report for a particular year is supported by the working papers contained in the current files many cpa firms have found it useful to organize the current files around the arrangement of the accounts in the client's financial statements the permanent file serves three purposes to refresh the auditor's memories on items applicable over a period of many years to provide new staff members with a quick summary of the policies and organization of the client and to preserve working papers on items that show relatively few or no changes much of the information contained in the permanent file is gathered during the course of the first audit of a client's records this chart shows the organization of the current files the administrative working papers usually begin with begin the current files including a draft of the financial statements and the auditor's report these working papers are followed by the working trial balance and the adjusting and reclassification entries the remaining portion of the current files consist of working papers supporting the balances and other representations in the client's financial statements this slide illustrates the guidelines for preparation of working papers a separate properly identified working paper should be prepared for each topic the working paper should be properly identified by a heading that includes the name of the client company a clear description of the information presented and the applicable date or the period covered if the working paper was prepared by the client staff it should be labeled pbc prepared by client and appropriately tested working papers should contain the initials of both preparer and reviewer as well as appropriate dates they should be properly indexed delete schedules and adjusting entries if any should be cross-referenced to adjusting entry work papers they should contain appropriate symbols called tick marks along with explanations to show what work was performed last the auditor's conclusion should be stated and this is the end of the presentation for chapter 5.