Chapter 7 - 2022

8/18/2022
AUDIT
EVIDENCE
CHAPTER 7
Copyright ©2017 Pearson Education, Inc. 7-

1
CHAPTER 7 LEARNING OBJECTIVES

1 Contrast audit evidence with evidence used by other professions.
2 Identify the four audit evidence decisions that are needed to create
an audit program.
3 Specify the characteristics that determine the persuasiveness of
evidence.
4 Identify and apply the eight types of evidence used in auditing.
5 Know the types of analytical procedures and their purposes. 7-6
Compute common financial ratios.
7-7 Understand the purposes of audit documentation.
7-8 Prepare organized audit documentation.
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2
OBJECTIVE 7-1
Contrast audit evidence with evidence
used by other professions.
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NATURE OF EVIDENCE
Table 7-1 contrasts audit evidence with legal and
scientific evidence.

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OBJECTIVE 7-2
Identify the four audit evidence
decisions that are needed to create
an audit program.
AUDIT EVIDENCE DECISIONS

The auditor must make four major decisions
regarding what evidence to gather and how much to
accumulate:
1. Which audit procedures to use?
2. What sample size to select for a given procedure?
3. Which items to select from the population?
4. When to perform the procedures?
An audit program includes all of the above
information for a given audit.

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OBJECTIVE 7-3
Specify the characteristics that determine
the persuasiveness of evidence.
PERSUASIVENESS OF EVIDENCE
Audit standards require that the auditor accumulate

sufficient appropriate evidence to support the opinion
issued.
The two determinants of the persuasiveness of evidence
are appropriateness and sufficiency.
Appropriateness of evidence depends on:
• Relevance of evidence
• Reliability of evidence

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PERSUASIVENESS OF EVIDENCE (CONT.)
Relevance of evidence means that the evidence must

pertain to or be relevant to the audit objective that is
being tested.
Reliability of evidence refers to the degree to which evidence is
believable or worthy of trust. Reliability depends on the following
characteristics:
1. Independence of provider
2. Effectiveness of client’s internal controls
3. Auditor’s direct knowledge
4. Qualifications of individuals providing the information
5. Degree of objectivity
6. Timeliness
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PERSUASIVENESS OF EVIDENCE (CONT.)

Sufficiency of evidence refers to the quantity of evidence obtained.
The sample size that is considered sufficient is affected by two
factors:
• The auditor’s expectation of misstatements
• The effectiveness of the client’s internal controls
Combined Effect—The persuasiveness of the evidence can be
evaluated only after considering the combination of
appropriateness and sufficiency.
In making decisions about audit evidence, both persuasiveness and

cost must be considered. The relationships among evidence
decisions and persuasiveness are illustrated in Table 7-2.
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OBJECTIVE 7-4
Identify and apply the eight types of
evidence used in auditing.
TYPES OF AUDIT EVIDENCE

Every audit procedure obtains one or more of the following
types of evidence:
1. Physical examination
2. Confirmation
3. Inspection
4. Analytical procedures
5. Inquiries of the client
6. Recalculation
7. Reperformance
8. Observation
Relationships among auditing standards, types of evidence, and the four
audit evidence decisions are shown in Figure 7-1.

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TYPES OF AUDIT EVIDENCE (CONT.)

1. Physical Examination—The inspection or count of a tangible asset by the auditor.
2. Confirmation—The receipt of a direct written response from a third party
verifying the accuracy of information that was requested by the auditor.
Information often confirmed is detailed in Table 7-3.
3. Inspection—The auditor’s examination of the client’s documents and records to
substantiate the information in the financial statements.
• Documents can be internal (prepared by the client’s organization) or external
(prepared or handled by someone outside the organization who is a party to
the transaction).
• Using documents to support recorded transactions (occurrence) is called
vouching.
• Testing from source documents to recorded amounts (completeness
objective) is called tracing.
PHYSICAL EXAMINATION
• Advantages of physical examination:

Assurance on the existence of the asset, quantity
and description of the asset or asset’s condition.
• Disadvantages of physical examination:
Providing little or no assurance on the ownership
objectives and proper valuation of asset
Exercise: Describe the physical examination of cash

on hand
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the transaction).
vouching.
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TYPES OF CONFIRMATION
• Positive confirmation: the recipient is request to return the
confirmation in all circumstances.
• Open confirmation: confirmation not included the figure to be
confirmed and this will be filled in by the responses of the third
party.
• Closed confirmation: confirmation included the figure to be
confirmed and the third party will confirm whether this figure is
correct or not , if not, differences required to be included.
• Negative confirmation: the recipient is request to response only
when the information is incorrect.
POSITIVE CONFIRMATION
Since there is a risk that recipients of a closed positive form of confirmation

request with the information to be confirmed contained on, it may sign and return
the confirmation without verifying whether the information is correct or not , blank
forms may be used as one way to mitigate this risk.
Thus, the use of blank confirmation requests may provide a greater degree of
assurance about the information confirmed. However, blank forms might result in
lower response rates because additional effort may be required of the recipients;
consequently, the auditor may have to perform more alternative procedures
CONFIRMATION
The auditor sent positive confirmation of account receivables to

customer but the auditor did not receive a response. What should
the auditor do?
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COMFIRMATION
Auditors normally send second and third times of confirmation to third
party and in some cases even request the client to contact the
independent third party and ask for responding to the auditor.
If all efforts fail, the auditor perform the following alternative audit
procedures:
 Examination of subsequent cash receipt
 Examination of customer orders, shipping documents and duplicate sale
invoices
 Examination of other client documentation

the transaction).
vouching.
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DOCUMENTATION
• Direction of testing:
Tracing (completeness)
Source
Ledger and journal
document
Vouching (Occurrence)
Vouching refers to selecting an item for testing from

accounting journals or ledgers and then examining
the supporting source document => testing for
occurrence
Tracing refers to selecting an accounting transaction
and the following it in the journal and ledger =>
testing for completeness.
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4. Analytical Procedures—The evaluation of financial information through analysis of
plausible relationships among financial and nonfinancial data and are required
during planning and completion phases of all audits. Purposes of analytical
procedures include:
• Understand the Client’s Industry and Business—Used in planning to gain
knowledge about the client.
• Assess the Entity’s Ability to Continue as a Going Concern—Many ratios can be
an indicator of potential financial problems.
• Indicate the Presence of Possible Misstatements in the Financial Statements—
The presence of unusual fluctuations noted in comparing current and prior
years could signal misstatements.
• Provide Evidence Supporting an Account Balance—If reliable relationships
exist, substantive analytical procedures can be used to support account
balances.
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5. Inquiry—Obtaining written or oral information from the client in

response to auditor questions. Usually not considered conclusive
unless it is corroborated.
6. Recalculation—Rechecking a sample of calculations made by the
client.
7. Reperformance—The auditor’s test of client accounting procedures
or controls.
8. Observation—Watching a process or procedure being performed by
others.
INQUIRY
Ex: inquiries of client personnel or management to understanding client’s
business or internal control.
 AD: easy to obtain this evidence and widely used in audit.
 DAD: Inquiry is not from independent sources and may be biased in the client’s
favor => is not considered high reliability => gather additional corroborative
evidence to support the client’s responses
 Closingquestion help the auditor to confirm the known matter. This question is to limit the
answers of interviewees. The answer of this type of question used the word “Yes or No”.
For example:
• Do you perform stock count every month?
• Do you carry out physical examination of cash on hand every day?
• Are the documents pre-numbered?
• Do you delete the name of employees from payroll report when he/she stopped working?
• Opening questions helps the auditor to obtain detail and adequate answers to collect
additional information. This type of question is normally used the word “what”, “why”,
“how”
• For example:
• How do you perform the stock count?
• Which payment procedures do you carry out?
• What is recruitment process?
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5. Inquiry—Obtaining written or oral information from the client in

response to auditor questions. Usually not considered conclusive
unless it is corroborated.
6. Recalculation—Rechecking a sample of calculations made by the
client. Ex: recalculate the depreciation expense, interest expense,…
7. Reperformance—The auditor’s test of client accounting procedures
or controls. Ex: the auditor may compare the price on an invoice to a
approved price list.
8. Observation—Watching a process or procedure being performed by
others.
OBSERVATION
Ex1: the auditor observes the separation of duties such as:
- Separation of custody of assets from accounting,
- Separation of operation responsibility from record-keeping responsibility.
Ex2: observe the condition of inventory whether it is obsolete or slow-moving
OBSERVATION
• AD: easy to obtain this evidence and widely used in audit, low cost.
• DAD: Observation is rarely sufficient by itself because there is a risk that

the client personnel involved in in those activities are aware of the
auditor’s presence.
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Appropriateness of Types of Evidence—Table 7-4 details the criteria to

determine appropriateness. Conclusions from the criteria:
• The effectiveness of a client’s internal controls has significant
influence on the reliability of most types of audit evidence,
especially internal documentation and analytical procedures.
• Physical examination and recalculation involve the auditor’s
direct knowledge and are likely to be highly reliable.
• Inquiry alone is usually not sufficient to provide appropriate
evidence to satisfy any audit objective.

Cost of Types of Evidence:
• Most expensive:
• Physical examination
• Confirmation
• Moderately costly:
• Inspection
• Analytical procedures
• Reperformance
• Least expensive:
• Observation
• Inquiries of
the client
• Recalculation
Terms used in
audit procedures
are defined in
Table 7-5.
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OBJECTIVE 7-5
Know the types of analytical procedures
and their purposes.
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ANALYTICAL PROCEDURES
Purposes of Analytical Procedures During the Audit Engagement:
1. Analytical procedures are required in the planning phase as
part of risk assessment to understand the client’s business
and industry.
2. Analytical procedures are often done during the testing phase
of the audit as substantive tests in support of an account
balance.
3. Analytical procedures are required during the completion
phase of the audit, serving as a final review for material
misstatements.

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ANALYTICAL PROCEDURES (CONT.)
Types of Analytical Procedures—Auditors compare client data with:

1. Industry data
2. Similar prior-period data
3. Client-determined expected results
4. Auditor-determined expected results
Internal comparisons and relationships are detailed in Table 7-6.

An example of a substantive analytical procedure is included in Figure 7-2.
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OBJECTIVE 7-6
Compute common financial ratios.
COMMON FINANCIAL RATIOS

Financial ratios fall into several categories:
• Short-Term Debt-Paying Ability:
• Cash ratio = (cash + Marketable securities)/Current liabilities
• Quick ratio= Cash + MS + Net AR)/ Current liabilities
• Current ratio = Current Assets/ Current liabilities
• Liquidity Activity Ratios:
• Accounts receivable turnover = Net Sale/Average gross receivables
• Days to collect receivables= 365 days/AR turnover
• Inventory turnover = Cost of good sold/average inventory
• Days to sell inventory = 365 days/inventory turnover

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COMMON FINANCIAL RATIOS (CONT.)
• Ability to Meet Long-Term Debt Obligations:

• Debt to equity = total liabilities/total equity
• Times interest earned = operating income/interest expense
• Profitability Ratios:
• Earnings per share = net income/ average common share outstanding
• Gross profit percentage = (net sales – COS)/Net sales
• Profit margin = operating income/Net sales
• Return on assets = income before taxes/ average total assets
• Return on common equity= (income before taxes – preferred
dividends)/ average stockholder’s equity)
OBJECTIVE 7-8
Prepare organized audit documentation.
AUDIT DOCUMENTATION
Audit documentation is the record of the audit procedures
performed, relevant audit evidence, and conclusions the auditor
reached.
Purposes of Audit Documentation:
• Basis for planning the audit
• Record of the evidence accumulated and the results of the tests
• Data for determining the proper type of audit report
• Basis for review by supervisors and partners
Ownership of the Audit Files: All audit files are the property of
the auditor.

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AUDIT DOCUMENTATION (CONT.)
Confidentiality of Audit Files:

The AICPA Code of Professional Conduct states that a member in public
practice shall not disclose any confidential client information without the
specific consent of the client.
Requirements for Retention of Audit Documentation:
• Auditing standards require records of private companies be retained
for a minimum of five years.
• Sarbanes-Oxley Act requires auditors of public companies to maintain
audit files for a minimum of seven years.
The contents and organization of a typical set of audit files is illustrated in

Figure 7-3. The type of audit documentation and the way it is arranged in the
files is logical although firms may vary in their approaches.
Permanent Files: Contain data of a historical or continuing nature. These
provide a convenient source of information that is used from year to year:
• Copies of company documents such as articles of incorporation, bylaws, bond
indentures, and long-term contracts
• Analyses of accounts from previous years that have continuing importance
• Information related to understanding internal controls and assessing control
risk
• Results of analytical procedures from prior years’ audits for comparison
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Current Files: Includes all documentation for the current year audit including:
• Audit Program
• Working Trial Balance—Each line in the trial balance is supported by a lead
schedule. A typical lead schedule for Cash is included in Figure 7-4.
• Adjusting Entries—Auditors propose adjusting entries for material
misstatements. An adjusting entry to Cash is illustrated in Figure 7-4.
• Supporting Schedules—Major types:
• Analysis
• Trial balance or list
• Reconciliation of amounts
• Substantive analytical procedures
• Summary of procedures
• Examination of supporting documentation
• Informational
• Outside documentation
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Preparation of Audit Documentation—Audit documentation should be in
sufficient detail to provide a clear understanding of the work performed,
evidence obtained, and conclusions reached.
Documentation should have these characteristics:
• Identified with the client’s name, period covered, description of the
contents, initials of the preparer, date of preparation, and an index
code.
• Files should be indexed and cross-referenced to aid in organization.
• Documentation should clearly indicate the audit work performed
through memos, initialing the procedures in the audit program, or tick
marks on the schedules.
• Include sufficient information to fulfill the audit objectives.
• Conclusions reached about the segment of the audit should be clearly
stated.
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Copyright ©2017 Pearson Education, Inc. 7-

CHAPTER 7 LEARNING OBJECTIVES

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Copyright © 2017 Pearson Education, Inc. 7-3

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Copyright © 2017 Pearson Education, Inc. 7-5

AUDIT EVIDENCE DECISIONS

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Audit standards require that the auditor accumulate

Copyright © 2017 Pearson Education, Inc. 7-

PERSUASIVENESS OF EVIDENCE (CONT.)

Relevance of evidence means that the evidence must

Copyright © 2017 Pearson Education, Inc. 7-9

Copyright ©2017 Pearson Education, Inc. 10

PERSUASIVENESS OF EVIDENCE (CONT.)

In making decisions about audit evidence, both persuasiveness and

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TYPES OF AUDIT EVIDENCE

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TYPES OF AUDIT EVIDENCE (CONT.)

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• Advantages of physical examination:

Exercise: Describe the physical examination of cash

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TYPES OF AUDIT EVIDENCE (CONT.)

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Since there is a risk that recipients of a closed positive form of confirmation

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The auditor sent positive confirmation of account receivables to

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TYPES OF AUDIT EVIDENCE (CONT.)

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Vouching refers to selecting an item for testing from

Copyright ©2017 Pearson Education, Inc.

TYPES OF AUDIT EVIDENCE (CONT.)

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TYPES OF AUDIT EVIDENCE (CONT.)

5. Inquiry—Obtaining written or oral information from the client in

Copyright © 2017 Pearson Education, Inc. 7-31

TYPES OF AUDIT EVIDENCE (CONT.)

5. Inquiry—Obtaining written or oral information from the client in

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Ex2: observe the condition of inventory whether it is obsolete or slow-moving

• DAD: Observation is rarely sufficient by itself because there is a risk that

TYPES OF AUDIT EVIDENCE (CONT.)

Appropriateness of Types of Evidence—Table 7-4 details the criteria to

Copyright © 2017 Pearson Education, Inc. 7-37

Copyright ©2017 Pearson Education, Inc. 7-38

TYPES OF AUDIT EVIDENCE (CONT.)

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ANALYTICAL PROCEDURES (CONT.)

Types of Analytical Procedures—Auditors compare client data with:

Internal comparisons and relationships are detailed in Table 7-6.

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