Chapter Two second part

What Is Auditing Evidence?

Auditing evidence is the information collected for review of a company's financial transactions,
internal control practices, and other items necessary for the certification of financial statements by
an auditor or certified public accountant (CPA). The amount and type of auditing evidence
considered vary considerably based on the type of firm being audited as well as the required scope
of the audit.

Characteristics of Auditing Evidence

Good auditing evidence can be measured by the extent of the following characteristics:

Sufficiency: Sufficiency takes into account whether or not the material provided is of an adequate
quantity that would allow auditors to make an accurate judgment. If an auditor was given just one
bank statement of a company, it would not be enough to make any determinations on the financial
standing of that company.

Reliability: Reliability seeks to determine whether or not the material can be trusted and counted
on for forming an opinion. Reliability typically factors from the source of the information.

Source: The source of accounting evidence can be obtained directly from the company or
externally. Externally sourced information is generally regarded as more trustworthy and is
therefore preferred.

Nature: Nature refers to the type of information that is received. For example, the information can
be provided through legal documents, presentations, orally from employees, or through a physical
confirmation.

Relevance: Depending on the type of audit being conducted, how pertinent the information
received is in relation to the overall analysis is a guiding factor.

In general, auditors prefer information that is written as opposed to that which is provided orally.
They also prefer:

• Information that is from a third-party source as opposed to that from inside the company
• Original documents as opposed to copies of those documents
• A strong understanding of the firm by the auditor to request appropriate auditing evidence
• Firsthand observations by the auditor as opposed to the documentation provided via
another source

Example of Auditing Evidence

Company ABC has enlisted the auditing services of the accounting firm, Anderson Brothers, to
have their financial statements from the fiscal year 2020 audited. The auditor begins working on

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the audit and requests information regarding reported revenues and bank balances. To obtain
accurate and reliable information, regarding revenues, the auditor requests sales receipts and
invoices and a physical examination of inventory. Regarding bank balances, the auditor requests
all of the bank statements of the company directly from ABC's bank. All of this information; the
receipts, invoices, physical observations, and bank statements are regarded as auditing evidence.

What Are the Types of Audit Evidence?

There are eight types of audit evidence. Each type has a specific purpose depending on the audit’s
goal, the client’s objectives, and the assertion being tested.

1. Physical examination. This involves inspecting tangible assets, such as inventory,

machinery, or documents, to verify their existence, condition, or ownership. Physical
examination provides direct evidence and is often documented in audit work papers.
2. Confirmations. This refers to relying on third parties such as banks to confirm various
aspects of the financial statements (for example, the closing bank balance or accounts
payable records).
3. Documentary evidence. Auditors will gather documentation such as internal process
documents, emails, or logs, to help with different portions of the overall audit. For example,
the auditors may use the documentation for vouching or tracing a process flow as a part of
the audit procedures.
4. Analytical procedures. This includes any analysis performed by the auditors using their
calculations to substantiate the financial information and any accounting records provided
by the client to find discrepancies.
5. Oral evidence. Auditors may hold question-and-answer sessions with their client’s senior
leadership team to inquire about the business operations when audit planning and designing
the audit procedures.
6. Accounting system. This allows the auditor to access financial reporting documents and
any information related to financial statements. The accounting system may also act as the
source of audit evidence.
7. Re-performance. The auditor assesses the control risk by re-performing key internal
control processes to check for deficiencies.
8. Observatory evidence. Auditors may observe activities or processes during site visits or
walkthroughs. This allows them to assess the effectiveness of internal controls, compliance
with regulatory requirements, or adherence to specific procedures.

How Is Audit Evidence Obtained?

Audit evidence is collected via audit procedures. Those procedures are categorized as risk
assessment procedures and audit procedures. The latter includes tests of controls and substantive
procedures.

There are seven types of audit procedures, and the purpose of the procedure typically dictates
which one is used:

1. Inspection. Auditors collect evidence by inspecting physical assets, records, or documents.

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 2. Observation. Auditors observe the client’s business processes and operations to identify
deficiencies.
3. Inquiry. Auditors talk with the client’s senior management to gain a deeper understanding
of business processes for the auditing process. Inquiry alone, however, isn’t considered
sufficient audit evidence to reduce the risk.
4. External confirmation. This involves obtaining written or oral responses directly from
third parties, such as customers, suppliers, or financial institutions
5. Recalculation. The auditors perform calculations to verify that the final account balances
match those reported by the client.
6. Reperformance. The auditor independently performs procedures or controls that were
originally performed by the entity to verify their effectiveness.
7. Analytical procedures. The auditor analyzes financial and non-financial data, such as
comparing current and prior year financial ratios or trends, to identify unusual fluctuations
or patterns that may indicate potential errors.

According to the Public Company Accounting Oversight Board (PCAOB), which regulates audit
firms in the United States, any audit evidence obtained must be sufficient and appropriate.

Sufficiency measures the quantity of audit evidence; appropriateness refers to the quality of audit
evidence. The sufficiency of the audit evidence is affected by both the risk of material misstatement
and the risk associated with the control and the quality of the audit evidence obtained.

Audit Documentation

Introduction

Financial audits ensure accuracy and complete transparency of the company's financial records.
This examination and evaluation paints the fair picture of the company to the stakeholders and
investors, making it easy for taking informed investing decisions.

Besides, these audits also help companies get a better understanding of their outlays, errors, and
other financial aspects. Auditors document all the checks and record them in physical mode for
future reference purpose. But what exactly is audit documentation?

Meaning of Audit Documentation

Audit documentation refers to written records created during the time of auditing, including
working papers, notes, and other related documentation. These records serve as evidence of the
auditor's work and support the auditor's audit report and opinions expressed. In essence, audit
documentation is a trail of evidence that allows auditors to trace their steps to the initial audit
planning, fieldwork, and conclusions.

Understanding Audit Documentation

Audit documentation precisely reflects the audit work done by the auditor. The documentation
should be complete, accurate, timely, and created and maintained as per professional standards.

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When creating and maintaining audit documentation, several important things must be considered.
First, auditors must document the planning process, including understanding the client's business
and risks and the overall audit strategy.

After that, the auditor must document the timing, nature of the audits, and even the procedures to
get the given results. Additionally, auditors should document every significant finding or issue that
arise during the audit and how those issues were resolved.

The audit documentation is the evidence of the auditor's work supporting the auditor's conclusions
and opinions expressed in the audit report. Audit documentation also serves as a tool for
monitoring and evaluating the quality of the audit and provides a base or reference point for
subsequent audits.

Importance of Audit Documentation

The importance of audit documentation cannot be left aside. It’s like taking notes of the whole
audit, stating every detail of the process.. The documentation helps to ensure that the audit report
accurately reflects the auditor's work. It provides a trail of evidence that allows the auditor to trace
their steps back to the initial audit planning, fieldwork, and conclusions. Audit documentation also
serves as a tool for checking the quality of the audit, which can also be used in future audits.

Process of Audit Documentation

The process of audit documentation begins with planning. During this stage, auditors must identify
the key areas of risk and the audit objectives. The auditor will then design audit procedures to
achieve these objectives. The auditor will also consider the entity's internal controls and the
potential risk of fraud.

The auditor then conducts fieldwork, which involves performing the audit procedures designed in
the planning stage. The auditor will collect evidence to support the audit conclusions during this
stage. The evidence collected will be in the form of working papers, notes, and other documents.

After fieldwork, the auditor will begin the process of evaluating the evidence. The auditor will
analyze the evidence collected and conclude the entity's financial statements. The auditor will also
evaluate the effectiveness of the entity's internal controls.

Things Auditors Record During Audit Documentation

Audit documentation is an essential component of the audit process. It provides evidence that
supports the auditor's opinion on the financial statements' fairness. Let's take a closer look at some
examples of audit documentation −

• Financial Statements − The financial statements are the starting point for any audit. They
summarize the entity's financial performance, including its balance sheet, income

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 statement, and cash flow statement. The auditor will use these statements to perform
analytical procedures, such as comparing current financial results to previous years.
• Audit Reports − The audit report is the auditor's opinion on the fairness of the financial
statements. It assesses the entity's internal controls, identifies any material weaknesses or
control deficiencies, and makes recommendations for improvement. The report also
explains the audit process and any limitations on the auditor's work.
• Working Papers − Working papers are the primary documentation that supports the
auditor's opinion. They include the results of the audit procedures performed, conclusions
reached, and any exceptions found. Working papers may include schedules, checklists, and
summaries of the auditor's findings. They serve as a record of the auditor's work and are
used to support the audit report.
• Notes and Other Documents − Notes and other documents provide additional details
about the audit procedures performed and any issues identified during the audit. These may
include emails, memos, and other correspondence between the auditor and the entity's
management. They provide further context for the auditor's work and help explain the basis
for the auditor's opinion.
• Internal Control Documentation − Internal control documentation includes policies and
procedures manuals, flowcharts, and other documentation that describe the entity's internal
controls. This documentation provides an understanding of the internal control
environment and its associated risks. The auditor will review this documentation to assess
the effectiveness of the entity's internal controls.

In a nutshell, these are some of the things recorded at the time of audit documentation. They are
essential for the audit process as they provide a record of the auditor's work and support the
auditor's opinion on the financial statements' fairness. By maintaining proper audit documentation,
auditors can ensure that they have performed the audit in accordance with applicable auditing
standards and regulations.

Meaning of Substantive Tests

Substantive procedures (or substantive tests) are those activities performed by the auditor during
the substantive testing stage of the audit that gather evidence as to the completeness, validity,
and/or accuracy of account balances’ and underlying classes of transactions.

Account balances and underlying transaction classes must not contain material misstatements.
They must be materially complete, valid, and accurate.

Auditors gather evidence about these assertions by undertaking substantive procedures, which may
include:

• Physically examining inventory on balance date as evidence that inventory shown in the
accounting records exists (validity assertion);
• Arranging for suppliers to confirm in writing the details of the amount owing at the balance
date as evidence that accounts payable is complete (completeness assertion); and
• Making management inquiries about the collectibility of customers’ accounts as evidence
that trade debtors are accurate in their valuation.

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Evidence that an account balance or transaction class is not complete, valid or accurate is evidence
of a substantive misstatement.

Substantive procedures are designed to obtain audit evidence regarding the completeness,
accuracy, and validity of data produced by the accounting system.

The accounting system of an organization generates various data concerning various transactions.
Their effect is reflected in the profit and loss account and balance sheet.

These transactions communicate one or more of the following assertions in financial statements.

1. Existence: that an asset/liability exists.

2. Rights and obligations: the enterprise has a right over the asset or has an obligation over
the liability.
3. Occurrence: that a transaction happened during the period, say, sales of so many Dollars
occurred.
4. Completeness: all transactions/assets/liability find a place in financial statements without
omission.
5. Valuation: the monetary values attached to asset or liability are correct or fair.
6. Measurement: that a transaction is recorded in a proper amount. Revenue or expense is
properly allocated to the period, e.g., prepaid expense, accrued income. E.g., freight paid
to bring machinery is included in the transaction about installation.
7. Disclosure: data is disclosed according to accounting convention, a statutory requirement.

These seven assertions of financial data may be correct or not.

A financial statement may depict a leasehold right as a freehold right. The auditor has to check to
ensure that these assertions are fairly represented in the financial statements.

To do this, he performs a substantive procedure.

Types of Substantive Procedures

There are two categories of substantive procedures;
1. Analytical Procedures
2. Tests of Details
1. Substantive tests of transactions
2. Tests of details of account balances and disclosures focus.

Analytical Procedures

Analytical procedures are an important part of the audit process and consist of evaluations of
financial information made by a study of plausible relationships among both financial and non-
financial data.

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Analytical procedures range from simple comparisons to complex models involving many
relationships and elements of data.

In the audit planning phase, analytical procedures serve as attention-directing devices.

Auditors use them to help determine their substantive procedures’ nature, timing, and extent.

Analytical procedures are used in this phase to increase the auditor’s understanding of the client
and identify specific audit risks by considering unusual or unexpected balances or relationships in
aggregate data.

Analytical procedures used in planning the audit might include the following:

• Account balance comparison of unadjusted trial balance amounts with adjusted tried
balance amounts of the prior year.
• Computation of significant ratios.
• Compare current year ratios to current industry ratios and prior year computing ratios.
• Computation of ratios using nonfinancial and financial data. E.g., sales per square foot of
sales space.
• Regression analysis.

2. Tests of Details

Tests of details are usually categorized into two types:

1. Substantive tests of transactions

Test for errors or fraud in individual transactions. Substantive transaction tests emphasize verifying
transactions recorded in the journals and then posted in the general ledger.

EX: An auditor may examine a large purchase of inventory by testing that the cost of the goods
included on the invoice is properly recorded in the inventory and accounts payable accounts.

2. Tests of details of account balances and disclosures focus.

Tests of details of account balances and disclosures focus on the items that are contained in the
financial statement- account balances and disclosures. Tests of details of balances consider the
closing balances in the general ledger.

Ex: The auditor may want to test accounts payable by examining a sample of individual invoices
that make up the ending balance of accounts payable.

Designing Substantive Tests

Substantive tests provide evidence about the fairness of each significant financial statement
assertion.

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Conversely, tests may reveal monetary errors or misstatements in the recording or reporting
transactions and balances.

Designing substantive tests involves determining the nature, timing, and extent of the tests
necessary to meet the acceptable level of detecting risk for each assertion.

1. Nature
2. Timing
3. Extent

1. Nature

The nature of substantive tests refers to the type and effectiveness of the auditing procedures.
When the acceptable level of detection risk is low, the auditor must use more effective and usually
more costly procedures.

When the acceptable level of detection risk is high, less effective and less costly procedures can
be used.

The three types of substantive tests are analytical procedures, a test of details of transactions, and
tests of details of balances.

2. Timing

The acceptable level of detection risk may affect the timing of substantive tests. If detection risk
is high, the test may be performed several months before the end of the year.

In contrast, when the detection risk for an assertion is low, the substantive tests will ordinarily be
performed at or near the balance sheet date.

3. Extent

More evidence is needed to achieve a lower acceptable level of detection risk than a high one. The
auditor can vary the evidence obtained by changing the extent of substantive tests performed.

The extent used in practice means the number of items or sample sizes to which a particular test
or procedure is applied.

Special Considerations in Designing Substantive Tests

Some special considerations relevant to designing substantive tests for selected types of accounts
are:

1. Income Statement Accounts

1. Analytical procedures for income statement accounts
2. Test of details for income statement accounts

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 2. Accounts Involving Accounting Estimates
3. Accounts Involving Related Party Transactions

1. Income Statement Accounts

Traditionally, tests of details of balances have focused more on financial statement assertions that
pertain to balance sheet accounts than on income statement accounts.

This approach is efficient and logical because each income statement account is inextricably linked
to one or more balance sheet accounts.

Examples include the following:

Balance Sheet Account Belated Income Statement Account

Accounts receivable Sales
Inventories Cost of sales
Prepaid expenses Various related expenses
Investments Investment Income
Plant assets Depreciation expense
Intangible assets Amortization expense
Accrued payables Various related expenses
Interest-bearing liabilities Interest expense

Because of these relationships, as compared with substantive tests of balance sheet accounts, tests
of income statement accounts rely more heavily on analytical procedures and less on tests of
details.

1. Analytical procedures for income statement accounts

Analytical procedures can be a powerful tool for obtaining audit evidence about income statement
balances.

This type of substantive testing may be used directly or indirectly. Examples include the following.

Account Analytical procedures

Hotel room
Number of rooms x Occupancy rate x Average room rate.
revenue
An average number of employees per pay period x Average pay per period x
Wages expense
Number of pay periods.

2. Test of details for income statement accounts

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When the evidence obtained from analytical procedures and test of details of related balance
accounts does not reduce detection risk to an acceptably low level, direct tests of details of
assertions about income statement accounts are necessary.

This may be the case when.

• Inherent risk is high.

• Control risk is high.
• Analytical procedures reveal unusual relationships and unexpected fluctuations.
• The account requires analysis.

2. Accounts Involving Accounting Estimates

An accounting estimate approximates a financial statement element, item, or account without exact
measurement.

Examples include periodic depreciation, the provision for bad debts, and warranty expense.

Management is responsible for establishing the process and controls for preparing accounting
estimates.

Judgment is required in making an accounting estimate. Accounting estimates may have a

significant effect on a company’s financial statements.

SAS 57, Auditing Accounting Estimates, states that the auditor’s objective in evaluating
accounting estimates is to obtain sufficient competent evidential matter to provide reasonable
assurance that

• All accounting estimates that could provide the material to the financial statements have
been developed.
• The accounting estimates are reasonable in the circumstances.
• The accounting estimates are presented in conformity with applicable accounting
principles and are properly disclosed.

In determining whether all necessary estimates have been made, the auditor should consider the
industry in which the entity operates, its methods of conducting business, and new accounting
pronouncements.

3. Accounts Involving Related Party Transactions

The auditor should identify related party transactions in audit planning.

These transactions concern the auditor because they may not be executed on an arms-length basis.

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The auditor’s objective in auditing related party transactions is to obtain evidential matter
regarding the purpose, nature, and extent of these transactions and their effect on the financial
statements. The evidence should extend beyond the inquiry of management.

In auditing related party transactions, the auditor is not expected to determine whether a particular
transaction would have occurred if the parties had not been related or what the exchange price and
terms would have been.

The auditor must determine the substance of the related party transactions and their effects on the
financial statements.

Developing Audit Programs for Substantive Tests

An audit program is a list of audit procedures to be performed.

The procedures are generally not listed by assertion or specific audit objective to avoid the multiple
listing of procedures that apply to more than one assertion or objective.

In addition to listing audit procedures, each audit program should have columns for;

1. cross-reference to other working papers containing the evidence obtained from each
procedure,
2. the initials of the auditor who performed each procedure, and
3. the date performance of the procedure was completed.

In any case, audit programs should be sufficiently detailed to provide:

• An outline of the work to be done.

• A record of the work performed.
• A basis for coordinating, supervising, and controlling the audit.

Difference between Tests of Controls and Substantive Tests

Points Test of controls Substantive tests

Audit procedures were performed to test Procedures are used during
controls’ effectiveness in preventing or accounting audits to check balance
Definition
detecting material misstatements at the sheets and other financial
relevant assertion level. documentation errors.
Determining the effectiveness of design
Determining fairness of statements
Purpose and operation of internal control structure
assertions.
policies and procedures
Primarily at or near the balance
Timing Primarily during interim work.
sheet date.

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Points Test of controls Substantive tests
The analytical procedure is a test of
Types Concurrent and additional. details of transactions and tests of
details of balances.
Test Deviations from control structure policies Monetary errors in transactions and
measurement and procedures. balances.
Risk component Control risk. Detection risk.
Inquiring, observing, inspecting, Same as tests of controls plus -
Applicable audit
reperforming, and computer-assisted audit analytical procedures, counting,
procedure
techniques. confirming tracing, and vouching.
Primary
fieldwork Second. Third.
standard
Required by
No. Yes.
GAAS

As you now covered substantive tests; check out explore complete guideline on auditing.

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