Audit Procedures and Evidence: A Comprehensive Guide
Audit Evidence and Claims Administration
Audit procedures gather evidence on implicit claims within financial statements. Auditors should relate these statements to risks and obtain sufficient evidence to support their opinion.
Claims Administration Criteria
These claims address criteria for registering and disclosing financial information in financial statements:
- Existence
- Completeness
- Rights and obligations
- Valuation
- Presentation
- Accuracy
Assertions about Financial Statements
- Existence or occurrence: Assets, liabilities, and equity reflect actual transactions.
- Completeness: All transactions, assets, liabilities, and equity are presented.
- Rights and duties: The entity has rights to assets and obligations for liabilities.
- Valuation or allocation: Amounts are determined according to generally accepted accounting principles (GAAP).
- Presentation and disclosure: Accounts are described and classified according to GAAP and include all necessary disclosures.
Many auditors also explicitly include:
- Accuracy: Arithmetical correctness of transactions.
- Cutoff: Register of operations within the correct accounting period.
Audit Evidence
Audit evidence corroborates or contradicts financial statement claims, forming the basis for the auditor’s opinion. It’s obtained through designed and applied audit tests.
Types of Audit Evidence
- Physical examination
- Confirmation
- Documentation
- Observation
- Inquiry
- Performance
- Analytical procedures
Physical Examination
The auditor inspects or counts a tangible asset. It’s a direct verification of an asset’s existence and is highly reliable. Examples: Inventory, cash, documents.
Confirmation
Receipt of a written or oral response from an independent third party verifying information. Examples: Bank confirmations, lawyer confirmations, client confirmations.
Documentation
Review of client documents supporting information in the financial statements. Examples: Invoices, contracts, deeds.
Observation
Using senses to assess activities; follow up initial impressions.
Inquiry
Written or verbal client responses to auditor questions; not always conclusive. Examples: Interviews.
Performance
Rechecking calculations and information transfers.
Analytical Procedures
Using comparisons and relationships to determine if account balances are reasonable. Example: Comparing profit margins.
Substantive Tests
Substantive tests check for errors affecting the accuracy of account balances.
- Substantive analytical tests: Comparing recorded amounts to auditor expectations.
- Substantive tests of details of balances: Concentrating on higher-value balances.
Audit Procedures
An audit procedure is a detailed instruction for collecting evidence. The procedure’s nature, sample size, number of items, and timing depend on the audit.
Examples of Audit Procedures
Tonnage
Main procedure: Physical count.
Bank Confirmation
Send a letter to the bank requesting the balance. Additionally:
- Reconciliation of bank balances
- Cutoff of entries
Recalculation of Interest on Investments
Global calculations check the approximate correctness of results.
- Valuation: Check market value to ensure adequate presentation.
- Collections: Check payments to accounts receivable.
- Study of uncollectible accounts: Accounts receivable with recoverability doubts should be provisioned.
- Physical inventory: Verify assets acquired are properly documented.
- Study of concept and maturity: Examine the concept to determine future benefit.
- Verification of subsequent payments: Review disbursements to liquidate liabilities.
- Review of deeds and contracts: Review shareholder agreements and contracts.
- Connecting to other accounts: Checking interest expense and accrued interest payable.
- Analysis of variations: Comparing figures year-over-year.
- Global calculations: For fixed-character concepts (revenue, income, rent).
Working Papers (WPs)
Working papers are records of evidence accumulated by the auditor. Examples include audit programs, memos, confirmation letters, and document summaries.
Objectives of Working Papers
- Organization and coordination of the audit.
- Information for the audit report.
- Support for the auditor’s opinion.
- Legal evidence.
- Basis for expert reports.
- Guide for subsequent audits.
Access to Working Papers
Working papers are owned by the auditor. Access should be granted only with the client’s written consent, and papers should remain under auditor control. Copying is generally not permitted.
Proposed Structure for Working Papers
- Permanent Files: Legal issues, financial issues, other topics.
- Planning Papers: Permanent information, year information, planning work.
- Audit Papers (Current Year): Summary of significant issues, item-specific sections.
Audit Report
The audit report documents the auditor’s work. Relevant factors include:
- Financial information prepared using GAAP.
- Consistent application of principles.
- Fair presentation of financial position, results, and cash flow.
- Reference to other auditors, if applicable.
- Comparative financial information.
Types of Audit Reports
- Standard Unqualified Opinion: Financial statements fairly present the entity’s financial position, results of operations, and cash flows in accordance with GAAP.
- Qualified Opinion: Except for the effects of a specific matter, the financial statements fairly present the information.
- Adverse Opinion: Financial statements do not fairly present the information.
- Disclaimer of Opinion: The auditor does not express an opinion.
Parts of the Audit Report
- Auditor’s opinion
- Financial statements
- Notes to financial statements (incorporation, significant accounting policies, notes to the balance sheet)
Analytical Procedures
Analytical procedures are evaluations of financial information through the study of relationships between financial and non-financial data. They involve comparing recorded amounts to auditor expectations.
Nature of Analytical Procedures
They range from simple trend analysis to complex mathematical models. Examples: Comparing current year revenues and expenses to prior periods; constructing a multiple regression model to estimate sales.
Importance of Analytical Procedures
- Discover differences or unexpected absences.
- Investigate potential errors.
- Requires auditor knowledge of the client and industry.
- Evaluate going-concern ability.
- Reduce detailed audit tests (if used as substantive evidence).
- Comprehensive review of financial statements.
Availability and Reliability of Data
Data availability and reliability should be evaluated based on the source. Factors influencing reliability include:
- Independent sources (outside or internal)
- Internal sources independent of those responsible for the audited amounts
- Reliable and adequate controls
- Data subject to revision
- Multiple sources used
Steps in Performing Analytical Procedures
- Create an expectation.
- Determine acceptable differences.
- Compare expectation to actual data.
- Investigate and assess significant differences.
Creating an Expectation
This can be done using:
- Prior period financial information
- Budgets and forecasts
- Relationships between financial elements
- Information from similar companies
- Relationships between financial and non-financial data
Research and Evaluation of Differences
Evaluate unexpected deviations. Management responses should be corroborated. If no explanation is sufficient, gather further evidence.
Preliminary Analytical Review
Purpose of the Analytical Review
Ensure financial statements are consistent with business knowledge, understanding of relationships and balances, and audit evidence. These procedures are not designed to provide substantial assurance on specific accounts.
Preliminary Analytical Review
Increase understanding of the client’s business and transactions. Identify areas posing audit risks.
Stages in Analytical Procedures
- Obtain financial and non-financial information.
- Compare the information.
- Analyze the results (review initial results, conduct further analysis, draw conclusions).
Materiality and Risk
Materiality
Materiality is the magnitude of an omission or misstatement that could influence a reasonable person’s decision. It’s often quantified (e.g., 2% of total assets, 10% of profit).
Levels of Materiality
- Unimportant amounts.
- Important amounts affecting financial statements.
Factors Affecting Materiality
- Materiality is relative, not absolute.
- Groundwork is needed to assess materiality.
- Qualitative factors also affect materiality.
Audit Risk
Audit risk is the risk that the auditor may improperly qualify their opinion. It’s a combination of inherent risk, control risk, and detection risk.
Inherent Risk
Inherent risk is the susceptibility of the financial statements to material misstatements before considering internal controls. It’s outside the auditor’s control. Factors include:
- Nature of the client’s business
- Economic and financial situation
- Organization and human resources management
Control Risk
Control risk is the risk that internal controls won’t detect or prevent errors. It’s also outside the auditor’s control. Factors include:
- Inadequate accounting systems
- Inadequate information systems
- Inadequate control systems
Detection Risk
Detection risk is the risk that audit procedures won’t detect material misstatements. It’s controllable by the auditor through procedure design and execution. Factors include:
- Ineffective audit procedures
- Poor application of procedures
- Problems defining scope and timing
Audit risk assessment is subjective and depends on the auditor’s judgment and experience. Levels of audit risk are often categorized as minimum, low, medium, or high.