Audit Evidence – Types, Sufficiency, and Evaluation

1. AUDIT 4 - 2015

2. AUDIT EVIDENCE

3. EVIDENCE Support for audit opinion Is all the information the auditor uses to arrive at the conclusions on which the audit is based. To support auditor’s opinion Must be obtained to support: • Risk assessment procedures • Tests of controls • Substantive procedures • Other audit procedures

4. Types of Audit Evidence • Accounting records – books & records (analytical, recalculation, & reconciliation) • Corroborative evidence – checks, invoices, sales orders, PO, contracts, minutes, confirmations, observation, inquiry & inspection – gives validity to the accounting data • Evidence in electronic form – consider the time during which information exists

5. Sufficient Appropriate Audit Evidence Must persuade the auditor that the ending balances are fairly presented Reasonable assurance only Persuasive rather than conclusive The auditor must exercise professional judgment Cost-benefit alone is not a valid basis

6. Sufficiency of Evidential Matter The auditor’s decision regarding the sufficiency of the evidence is influenced by the following: • The risk of material misstatement – (greater risk = more evidence) • Quality – less audit evidence may be required when that evidence is of higher quality

7. Appropriateness of Audit Evidence Must be reliable and relevant. • Circumstances under which it is gathered • Source of the evidence • Nature of the evidence

8. Appropriateness of Audit Evidence • Auditor’s direct personal knowledge – provides persuasive evidence than evidence obtained indirectly (observation, recalculation, inspection) • External evidence – provides greater assurance than internally generated evidence. • Sent directly to the auditor (confirmations, legal letters, bank cut-off statements) • Received and held by the client (bank statements, contracts, invoices) • Internal evidence (purchase orders, sales orders, receiving reports) – internal controls • Oral evidence – least reliable form of evidence

9. Hierarchy of Audit Evidence (From most reliable to least reliable) • Auditor’s personal knowledge • External evidence • Internal evidence • Oral evidence

10. Evaluation of Audit Evidence • Evaluate management assertions • Detect material misstatements The evaluation of audit evidence must take into consideration the achievement of audit objectives

11. Substantive Procedures = $ balances Tests of details – to gather evidence to support the account balances as reflected in the F/S • Performed on ending balances • Performed on the details of transactions Analytical procedures – ratios, %, comparisons. The auditor looks for unusual relationships, discrepancies, or variances. • Planning – required (understanding) • Substantive tests – Not required (audit evidence) • Final review – required (overall reasonableness)

12. Analytical Procedures Documentation requirements: • Auditor’s expectation • Factors considered in the development • Results of the comparison • Additional procedures performed in response to significant unexplained differences • Results of such additional procedures Types of analytical: • Vertical / horizontal analysis • Ratio analysis

13. Analytical Procedures Limitations: • Differences do not necessarily indicate errors or fraud. • Differences simply indicate the need for further investigation

14. Substantive Procedures – Tests of Details A. Directional testing • If a test starts with items in the accounting records, the proper assertion is most likely to be existence (vouching). • If a test starts with source documents, it is most likely related to the completeness assertion (tracing).

15. Substantive Procedures – Tests of Details B. External confirmation • Direct written response from a third party • Positive vs. negative • The auditor should maintain control • Non responses • Oral responses • Exceptions – difference reported

16. C. Standard Auditing Procedures • Footing, crossfooting, and recalculation – math accuracy - Valuation • Inquiry – both internal sources & external sources (attorneys & bankers) – Presentation & disclosure • Vouching –support for what has been recorded- Existence • Examination/Inspection – careful examination of documents & records (minutes, contracts, invoices) 0-Existence • Confirmation – written verification - Existence • Analytical procedures - Completeness • Reperformance – Valuation

17. Standard Auditing Procedures • Reconciliation – substantiates the existence & valuation of accounts. It involves comparing financial amounts from two independent sources for agreement. • Observation – direct personal knowledge. (existenceor occurrence) • Tracing – starts with the source documents and traces forward to provide assurance that the event is being given proper recognition in the books & records (completeness) • Cutoff review of year end transactions –Completeness, Rights & obligations

18. Standard Auditing Procedures • Auditing related accounts simultaneously (LTD/ Interest) • Representation letter - Presentation and disclosures • Subsequent events review - Valuation

19. Relevant Assertions • Account balances • Completeness • Valuation • Existence • Rights and obligations

20. Relevant Assertions 2. Transactions and events • Completeness • Cut-off • Valuation • Existence • Understandability & classification

21. Relevant Assertions 3. Presentation & disclosure • Completeness • Valuation • Rights and obligations • Understandability and classification

22. Selection of Items • Selecting all items – small number of high dollar value items • Selecting specific items – all items that have a specific characteristic • Audit sampling – less than 100% (to be discussed in chapter #5)

23. Completeness Tracing from source documents to the financial statements Analytical review procedures Observation of processes and procedures Procedures to Assertions

24. Cut-off Cut-off procedures Procedures to Assertions

25. Allocation & Valuation Recalculation (allowance) Reconciliation of schedules to G/L Procedures to Assertions

26. Existence Confirmations Observation, inspection, and examination Procedures to Assertions

27. Rights & Obligations Inspection of documentation supporting transactions, inspection of contracts Procedures to Assertions

28. Understandability and classification Review of all related disclosures for compliance with GAAP Inquiry of management regarding disclosures for the account Procedures to Assertions

29. Audit Procedures by Transaction Cycle

30. Cycles

31. Revenue Cycle – Fraud Risk • Early revenue recognition • Holding books open • Fictitious sales • Failure to record sales returns • Side agreements to sell more inventory than needed • Understating the allowance

32. Revenue Cycle Sales Department • Receipt of a customer purchase order • Serially numbered sales order • Sent to credit department for approval Credit Department • Approval of sales order • Copy sent to: • Shipping department • Billing department • Accounting department

33. Revenue Cycle Shipping Department • A serially numbered bill of lading is prepared • Copy is sent to customer • Goods are shipped and a receivable arises Billing Department • Prepares a serially numbered sales invoice • Shipping documents, sales order & invoices are compared for completeness & mathematical accuracy • Invoice is sent to customer and to A/R Dept

34. Revenue Cycle Accounts Receivable Department • Sales is entered into the sales journal, and a receivable is recorded • Periodically, an independent person should reconcile the G/L and the A/R subsidiary records • When payment is received, the receivable is eliminated • Uncollectible are sent to Credit Manager for follow up • Treasurer should authorize write-offs • Serially numbered receiving report may be used as to sales returns • Sales discounts procedures and records should be reviewed to ensure that discounts are properly given and recorded

35. Cash Receipts Collection of cash receipts Incoming mail must be opened by a person who does not have access to the A/R ledger Receipts should be listed in detail • A copy & actual receipts sent to the cashier for bank deposit • Another copy to the A/R Dept. for entry in the A/R ledger • Another copy to the accounting dept. for entry into the G/L Cash collections should be restrictively endorsed upon receipt and deposited daily Devices such as cash registers or lock boxes should be used as safeguards

36. Substantive Procedures - Revenue Cycle • Auditing accounts receivable – • Completeness – obtain an aged trial balance of accounts receivable & trace the total to the general ledger control account • Valuation, allocation & accuracy – examine the results of confirmations and test the adequacy of the allowance • Existence & occurrence – confirm a sample of accounts receivable • Rights & obligations – review bank confirmations and debt agreements for liens. Also, inquire management

37. Substantive Procedures - Revenue Cycle 2. Auditing sales transactions – • Completeness – trace a sample of shipping documents to the sales invoices, and to the sales journal and accounts receivable ledger • Cut-off – compare a sample of invoices from shortly before and after year end with the shipment dates & with the dates the sales were recorded • Valuation, allocation & accuracy – compare prices on a sample of invoices with price lists and terms • Existence & occurrence – vouch a sample of sales transactions from the sales journal to the customer order and shipping documents • Understandability & classification – examine a sample of invoices for proper classification into revenue accounts

38. A/R - Confirmations Confirmations is considered a required procedure unless: • Receivables are immaterial • Confirmation would be ineffective • Inherent & control risks are very low & evidence provided by other procedures is sufficient Provides evidence regarding existence and rights & obligations

39. Evidential Procedures – A/R Positive confirmations (existence): • Large accounts, expected errors, or items in dispute, and when internal control is weak. • May be blank confirmations / detail • Confirmations received electronically • Non responses should be followed up with 2nd and 3rd requests • Alternative procedures • Subsequent collections • Invoices / shipping documents

40. Evidential Procedures – A/R Negative confirmations (existence): • The combined assessed level of inherent & control risk is low • A large # of small account balances are being confirmed • There is no reason to expect that recipients of the requests will be unlikely to give them consideration

41. Expenditure Cycle Purchases • Purchase requisition – should be approved and pre-numbered • Purchase orders – prepared only after proper approval. Should be sent to: • Requisitioning department • Vendor • Receiving department • Accounting department

42. Expenditure Cycle Receiving Department The PO serves as an authorization to accept the goods when they arrive Forced to count A pre-numbered receiving report is prepared

43. Expenditure Cycle Accounts payable Department Recording the payable after comparing PO, RR & invoice Records as inventory and records a payable After matching and close to due date, documents are sent to the Treasurer

44. Expenditure Cycle Treasury Department Treasurer prepares, signs, and mails the checks and cancel all supporting documents after payment. Paid vouchers are returned to the accounting department for posting of the payment and filing of the documents

45. Substantive Audit Procedures - Expenditures • Auditing accounts payable • Completeness • Agree accounts payable listing to G/L • Obtain a sample of vendor statements and agree to the vendors accounts • Perform a search for unrecorded liabilities • Valuation, allocation, & accuracy • Foot the A/P listing and agree totals to the general ledger • Obtain a sample of vendor statements and agree to the vendors accounts • Review the results of accounts payable confirmations

46. Substantive Audit Procedures – A/P • Existence and occurrence • May confirm accounts payable balances (not required) • Vouch selected amounts to the voucher packages • Rights & obligations • Review a sample of voucher packages for the presence of the purchase requisition, purchase order, receiving report, and vendor invoice to verify ownership

47. Auditing Purchase Transactions A/P • Completeness • Trace a sample of vouchers to the purchase journal • Cut-off • Valuation, allocation, & accuracy • Recompute mathematical accuracy of a sample of vendors invoices • Existence • Test a sample of vouchers for authorization and the presence of a receiving report • Understandability & classification • Verify the account classification of a sample of purchases

48. Auditing Presentation & Disclosure A/P • Completeness • Payables by type • Purchase contracts & commitments • RPT • Expenses by segment • Valuation, allocation, & accuracy • Determine whether the info is accurate and presented at the appropriate amounts • Rights & obligations • Compare disclosures to other audit • Understandability & Classification • Read all notes to make sure they are understandable

49. CASH Fraud Risk Lapping – theft is concealed by failing to account for cash receipts • Prevent using a lock-box system Kiting – to cover a cash shortage or to pad a company’s cash position • Detect preparing a “Bank Transfer Schedule”

50. CASH Audit Procedures • Auditing the ending cash balance • Completeness, valuation & existence • Bank confirmation • Bank reconciliation • Cut-off bank statement • Auditing cash receipts and disbursements • Completeness – trace a sample of remittance advices to the cash receipts journal and deposit slips • Cut-off – perform tests • Valuation – Foot the deposit slips and agree to the cash receipts journal and bank statement