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

  1. Existence or occurrence: Assets, liabilities, and equity reflect actual transactions.
  2. Completeness: All transactions, assets, liabilities, and equity are presented.
  3. Rights and duties: The entity has rights to assets and obligations for liabilities.
  4. Valuation or allocation: Amounts are determined according to generally accepted accounting principles (GAAP).
  5. 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

  1. Organization and coordination of the audit.
  2. Information for the audit report.
  3. Support for the auditor’s opinion.
  4. Legal evidence.
  5. Basis for expert reports.
  6. 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

  1. Permanent Files: Legal issues, financial issues, other topics.
  2. Planning Papers: Permanent information, year information, planning work.
  3. Audit Papers (Current Year): Summary of significant issues, item-specific sections.

Audit Report

The audit report documents the auditor’s work. Relevant factors include:

  1. Financial information prepared using GAAP.
  2. Consistent application of principles.
  3. Fair presentation of financial position, results, and cash flow.
  4. Reference to other auditors, if applicable.
  5. 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

  1. Auditor’s opinion
  2. Financial statements
  3. 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

  1. Discover differences or unexpected absences.
  2. Investigate potential errors.
  3. Requires auditor knowledge of the client and industry.
  4. Evaluate going-concern ability.
  5. Reduce detailed audit tests (if used as substantive evidence).
  6. 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

  1. Create an expectation.
  2. Determine acceptable differences.
  3. Compare expectation to actual data.
  4. 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

  1. Obtain financial and non-financial information.
  2. Compare the information.
  3. 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

  1. Unimportant amounts.
  2. Important amounts affecting financial statements.

Factors Affecting Materiality

  1. Materiality is relative, not absolute.
  2. Groundwork is needed to assess materiality.
  3. 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.