1. Chapter 7
Audit Evidence:
A Framework
Copyright © 2010 South-Western/Cengage Learning

2. Audit Opinion Formulation Process

3. Overview
• Auditing is a process of objectively gathering, evaluating,
and documenting the evidence needed to provide assurance on
the financial statements
• In planning an audit, three questions need to be answered:
– What audit procedures should be performed?
– How much evidence is needed?
– When should the audit procedures be performed?
The audit programs detail the auditor's plan to gather, evaluate, and
document evidence

4. Overview (continued)
• The evidence gathering process is the core of the
audit; evidence is needed to
– Reduce audit risk
– Support the opinion
• In deciding which evidence to gather, the auditor
considers
– Risk associated with an account balance or other measures
of performance
– Types of evidence available
– Reliability of alternative sources of evidence

5. LO 1 Third Standard of Fieldwork
Sufficient, competent evidential
matter is to be obtained through
audit procedures performed to afford
a reasonable basis for an opinion
regarding the financial statements
under audit

6. What is the assertion model?
• The auditor gathers evidence to evaluate the
management assertions embodied in the
financial statements and individual accounts
• Existence or occurrence
• Completeness
• Rights and obligations
• Valuation or allocation
• Presentation and disclosure

7. LO 3 Gathering Sufficient,
Appropriate Evidence
• Because each audit is unique, there is no set amount or type of
evidence that must be gathered
• When considering the best approach to gather evidence, the
auditor needs to consider factors affecting the reliability of the
financial data:
– Management integrity
– Client economic risk
– Quality of client's information system
– Client's internal controls
– Current market conditions and competitor actions

8. The Steps in the Overall
Audit Process
1. Understand the client and industry
2. Assess environment risk
3. Test details of transactions and/or
account balances
4. Assess adequacy of evidence

9. Sufficiency
• Evidence must be convincing and of sufficient
quantity to convince the audit team of the correctness
or incorrectness of an account balance.
• When gathering evidence, auditors consider which
procedures provide the most reliable evidence in the
most efficient manner
• Reliability depends on the circumstances under which
evidence is gathered:

10. Sufficiency (continued)
– Evidence obtained from independent outside sources is
more reliable than evidence obtained from the client
– Evidence obtained from auditor's direct knowledge is
more reliable than evidence obtained indirectly
– Evidence obtained from client with strong internal
controls is more reliable than evidence obtained from
client with weak internal controls

11. Internal Documentation
Reliability varies with
– Quality of client's internal controls
– Management's motivation to misstate (fraud
potential)
– Formality of the documentation including
acknowledgement by independent parties
– Preparation of the document independently of the
accounting system and management

12. External Documentation
• Generally considered highly reliable
• External documents provided by a
client should be viewed more critically
than documents received directly from
the external party

13. Paper vs. Electronic Documentation
• Major challenge for auditors to determine which
electronic data is reliable
• Computer systems can be designed to provide
safeguards similar to paper-based systems
• If auditor is going to rely on electronic data, he/she
must develop an understanding of the
– Client's computer system
– Controls used to safeguard electronic data from
manipulation or destruction

14. The Nature of Audit Testing
• When directly testing an account balance or
transactions, the auditor examines two basic
types of evidence
– The underlying accounting data and records
– Corroborating information that validates the
underlying accounting data

15. The Nature of Audit Testing (continued)
• Auditors have traditionally used direct tests of
year-end account balances, as opposed to
examining the transactions that make up the
account balance
Generally,
– There are usually fewer items in the ending
balance than the number of underlying transactions
during the year
– More reliable evidence usually exists for an ending
balance than for the underlying transaction

16. The Nature of Audit Testing (continued)
• However, for many long term accounts (assets,
liabilities, owners' equity), the auditor may
focus on the transactions that occurred during
the audit period
• For these accounts,
– There are usually fewer transactions during the
year than items in the ending balance
– Reliance forms of evidence are often available

17. Audit Procedures
• The procedures an auditor will use vary
according to the risks associated with the client
and the methods used to record transactions.
• Three major phases of the audit:
– Preliminary planning and risk analysis
– Understand and test system
– Test account balances and transactions

18. Audit Procedures: Preliminary
Planning and Risk Analysis
• Review prior-year audit work
• Review publicly available data about the
organization
• Perform analytical procedures
• Inquire of management and employees
• Perform internal control walkthroughs

19. Audit Procedures: Understand and
Test the System
For all systems:
– Inquire of management and supervisory personnel
– Review system documentation
– Observe system in operation
– Document system flow and control points
– Determine the effectiveness of procedures
– Select transactions and trace through processing
Additional work for computerized systems:
– Test important computer controls
– Use computer software to trace transactions through system
– Use software to select transactions for further verification

20. Audit Procedures: Test Account
Balances and Transactions
• Review authoritative records and documents
– Vendor invoices and monthly statements
– Receiving and shipping records
– Legal documents and others
• Testimonial evidence:
– Inquire of client personnel
– Inquire of outside parties

21. Audit Procedures: Test Account
Balances and Transactions (continued)
• Auditor-generated evidence:
– Direct observation
– Perform re-computations
– Reprocess transactions from source documents to accounting
records
– Vouch transactions from accounting records back to source
documents
– Physically examine assets
– Perform analytical procedures
• Each of these procedures has strengths and weaknesses; the
auditor's task is to determine which procedures provide a
sufficient level of evidence with the least amount of audit
cost

22. LO 4 Directional Testing
(Audit Efficiency)
• Directional testing: auditor tests for over- or
understatement, not both Increases audit efficiency
– Misstatements are more likely to occur in one direction
(assets and revenues overstated, liabilities and expenses
understated)
– With directional testing, auditor uses procedures that focus
on the most likely misstatements
– Vouching and reprocessing are examples of directional
tests
– Can also provide evidence about complementary accounts
– Some management assertions are directional by nature
(existence addresses overstatement; completeness,
understatement)

23. LO 5 Commonly Used Audit
Procedures
• Auditors use a variety of procedures to gather
evidence
• For certain accounts or management assertions,
certain procedures may be more efficient or effective
than other procedures
• When writing audit programs, the auditor tries to use
those procedures
• The primary types of audit procedures include:
– Observation of client personnel and procedures

24. LO 5 Commonly Used Audit
Procedures (continued)
– Physical examination of assets
– Inquiry
– Confirmations
– Examination of documents
– Re-computation of data
– Reprocessing transactions
– Vouching transactions
– Analytical procedures

25. Commonly Used Audit Procedures
(continued)
Observation of client personnel and procedures
– Most often used to gain an understanding of client
processing system
– Also used to observe counting of physical
inventory
– Limitations:
• Intrusive and time-consuming
• Employees know they're being watched and act
differently; this makes it difficult to generalize the
evidence obtained

26. Commonly Used Audit Procedures
(continued)
Physical examination of assets
– Useful in verifying existence of tangible assets
– May be useful in identifying potential
obsolescence or wear and tear
– Does not provide evidence on completeness,
ownership, or proper valuation (except as in item
above)

27. Commonly Used Audit Procedures
(continued)
Inquiry
– Used extensively, especially early in the audit to gain
an understanding
– Efficient way to gather evidence
– Not considered persuasive, should be corroborated by
other sources of evidence
Confirmations
– Auditor sends letter to outside party asking them to
verify client information
– Considered strong evidence because they come from
external parties

28. Commonly Used Audit Procedures
(continued)
– Limitations:
• Respondents may not adequately check information
being confirmed
• Respondents may not respond in a timely fashion
• Respondents may not challenge figures in their favor

29. Commonly Used Audit Procedures
(continued)
Examination of documents
– Much of the audit process involves examining documents
– Useful for evaluating all of the assertions
– Auditor should establish document authenticity in order to
rely on it
Recalculation
– Includes footing, cross-footing, tests of extensions, re-
computation
– Often used to test accuracy of estimated accounts and
allowances

30. Commonly Used Audit Procedures
(continued)
Test of transactions involve reconciling source
documents with recorded accounting information
Reprocessing
– Select sample of source documents and reprocess them to
make sure they have all been properly recorded
– Includes reviewing journalizing and posting of the
transaction
– Helps establish completeness (all valid items have been
recorded)

31. Commonly Used Audit Procedures
(continued)
Vouching
– Reverse of reprocessing
– Select sample of already recorded transactions and trace
back to the underlying source documents
– Helps establish that recorded transactions are valid
(existence)
Analytics
– Compare recorded account balances (or ratios of balances)
to expectations developed by the auditor
– Sources used to develop these expectations include client's
prior period information, industry data, expected results

32. Timing of Procedures
In addition to what procedures to perform, the auditor
must also decide when to perform them
– As of the balance sheet date
– After the balance sheet date
– Before the balance sheet date (interim testing)
Advantages of interim testing:
– Audit may be completed, and statements distributed, sooner
– Typically means less overtime for audit staff

33. Timing of Procedures (continued)
Disadvantages of interim testing:
– Risk of material misstatement between interim date and
year-end
Interim testing is feasible:
– When client has strong internal controls
– When there is low probability of significant change in
account balances between interim work and year-end
– For accounts in which the auditor focuses on tests of
transactions rather than the year-end balance (example:
non-current assets)

34. Extent of Procedures
In addition to deciding what procedures to perform and when to
perform them, the auditor must also decide how much evidence is
needed
The extent of testing is affected by:
– Auditor's assessment of the risk of account balance misstatement
– Amount of misstatement considered material
– Persuasiveness of alternative forms of evidence
The amount of evidence may also be influenced by the auditor's
individual risk preferences

35. LO 6 Audit Programs and
Documenting Audit Evidence
• Audit programs specify the audit objectives and
procedures used to gather, document, and evaluate
evidence
• Audit programs guide the conduct of the audit and
provide an effective means for:
– Organizing and distributing audit work
– Monitoring the audit process
– Recording audit work performed
– Reviewing the audit procedures performed and evidence
gathered

36. LO 7 Documenting Audit Evidence
The audit work papers include all forms of
documentation including:
– Evidence of planning, including audit programs
– The client's trial balance and any auditor adjustments
– Copies of selected internal and external documents
including confirmation and representation letters and
abstracts of company documents
– Schedules prepared or obtained by the auditor
– Auditor memos
– Results of analytical procedures and tests of client records
– Auditor analysis of account balance

37. Audit programs
• The work papers are the primary evidence in support
of audit conclusions and should cover all relevant
audit work, support the audit report, and leave no
significant points unresolved
• The work papers aid in the conduct and supervision
of the work, facilitate performance of an effective
review, demonstrate adherence to professional and
Firm auditing standards and procedures, and assist in
planning the following year's audit

38. Characteristics of Good Audit
Documentation
Well-developed audit documentation contains:
– A heading that includes client name, explanatory
title, and balance sheet date
– Initials of the auditor who prepared the
documentation and date completed
– Initials of the reviewer and date review completed
– Description of the tests performed and the findings
– Assessment of whether tests indicate material
misstatement in an account

39. Characteristics of Good Audit
Documentation (continued)
– Tick marks and legend indicating work performed
by the auditor
– Index to identify the location of papers
– Cross-reference to related documentation, when
applicable

40. LO 8 Auditing Account Balances Affected
by Management’s Estimates
• Account balances are based on information gathered
related to making estimates, appraisals, or other
management assumptions
• These accounts include
– Estimated warranty liability
– Evaluation of fixed assets
– Analysis of goodwill
• Evidence used in Auditing Management’s Estimates
– Auditors should evaluate the processes used by
management in making estimates