Audit 4 - Audit Evidence Flashcards
What is audit evidence?
All the information used to arrive at the conclusions on which audit opinion is based
When is audit evidence gathered?
When performing: risk assessment procedures, tests of controls, substantive procedures, and other audit procedures
What are the types of evidence?
- Accounting records
- Corroborating evidence
- Evidence in electronic form
How does an auditor test accounting records?
Through analytical procedures and substantive procedures, such as retracing procedural steps, recalculation, and reconciliation
What does corroborating evidence include?
Minutes of meetings, confirmations, industry analysts’ reports, data about competitors, and info obtained through observation, inquiry and inspection
What is the objective of substantive testing?
To detect material misstatement in financial statements
What must the audit evidence persuade the auditor of?
That the ending balances in the F/S are fairly presented
Sufficiency of evidence is influenced by…
- The RMM: greater risk implies more evidence will be required
- The quality of evidence: less audit evidence may be required when that evidence is of higher quality
Appropriate audit evidence must be both…
Reliable and Relevant
Reliability of audit evidence is dependent on..
The circumstances under which it is gathered – is also influenced by its source and nature
Hierarchy of audit evidence
- Auditor’s direct personal knowledge & observation
- External evidence
- Internal evidence
- Oral evidence
Auditor’s direct personal knowledge examples
Observation, physical examination, inspection, or recalculation
External audit evidence example
- Evidence sent directly to an independent auditor (bank confirmation)
- Evidence received and held by the client
Internal evidence examples
Purchase orders, sales orders, general ledgers, and management reports (validity strengthened by good I/C)
Oral evidence examples
Statements made by clients concerning the procedures involved in a given transaction, often resulting in the explanation of an account balance
What should the auditor do if he/she intends to use information produced by the client?
Determine if the information is sufficiently reliable
To be relevant, audit evidence must…
Relate to the F/S assertion(s) under consideration
The evaluation of audit evidence must take into consideration…
The achievement of audit objectives
What do substantive procedures consist of?
Tests of details applied to transactions, balances and disclosures, and substantive analytical procedures
Tests of details consist of…
Audit procedures used to gather evidence to support the account balances as reflected in the F/S.
What are tests of details performed on?
Ending balances, the details of transactions, or a combination of the two
What are analytical procedures?
Evaluations of financial information made by a study of plausible relationship among both financial and nonfinancial data. Generally involve comparisons of recorded amounts to independent expectations developed by the auditor
When are analytical procedures required?
Planning and final review stages of the audit
What are types of analytical procedures?
Comparisons of financial data, and ratio analysis
When should analytical procedures be used as substantive tests?
When they are more effective and efficient means of gathering evidence than tests of details
When designing and performing analytical procedures as substantive procedures, the auditor should…
- Determine suitable procedures
- Evaluate reliability of data from which expectation is to be based
- Develop expectation and evaluate whether the expectation is sufficiently precise to identify material misstatement
- Perform analytical procedure and compare results to expectation
- Investigate significant differences, if any
What does the efficiency and effectiveness of analytical procedures depend on?
- Nature of assertion being tested
- Plausibility and predictability of the data relationship
- Availability and reliability of data used to develop the expectation
- Precision of the expectation
What are the documentation requirements when analytical procedures are used as the principal substantive test of a significant F/S assertion?
- Auditor’s expectation
- Factors considered in the development of the expectation
- Results of the comparison of the expectation to recorded amounts
- Addt’l audit procedures performed
- Results of addt’l procedures
Tracing
FORWARD: from source documents to journal entries. Provides evidence of completeness
Vouching
BACKWARD: from journal entries to source documents. Provides evidence of existence/occurrence
What is external confirmation?
A direct written response to the auditor from a third party, either in paper form or by electronic or other medium
What is a positive confirmation?
A request that the confirming party respond directly to the auditor by providing the requested information or by stating whether they agree or disagree with the information in the request
What is a negative confirmation?
A request that the confirming party respond directly to the auditor only if the confirming party disagrees with the information in the request
The auditor should maintain control over external confirmation requests, including…
Information to be confirmed, selecting appropriate confirming parties, designing the confirmation requests, and sending requests and follow-up requests
For each confirmation nonresponse, the auditor should…
Perform alternative procedures
When responses are received electronically, the auditor should…
Contact the confirming party to validate the identity of the sender and the accuracy of the information received
What is a confirmation exception?
A response that indicates a difference between the information in the entity’s records and the information provided by the confirming party. Investigate all differences to verify whether they are indicative of material misstatement, fraud, deficiencies in I/C over financial reporting
What are the standard auditing procedures?
FIVE CARROT CARS;
- Footing, cross-footing and recalculation
- Inquiry
- Vouching
- Examination/inspection
- Confirmation
- Analytical procedures
- Reperformance
- Reconciliation
- Observation
- Tracing
- Cutoff Review
- Auditing related accounts simultaneously
- Rep letter
- Subsequent events review
Footing, cross-footing, and recalculation
Verifying the mathematical accuracy
Inquiry
Consists of requesting information from knowledgeable parties both internally and externally
Vouching
Directional testing in which the auditor examines support for what has been recorded in the records and statements
Examination/inspection
Generally provides evidence about the existence assertion, rather than about ownership, rights, obligations, or valuation
Confirmation
Specific type of inquiry that involves obtaining representations form independent external third parties about account balances and transactions or events
Analytical procedures
Evaluations of financial information made by a study of meaningful relationships among data, to help highlight unusual fluctuations that could be the results of errors or fraudulent omissions or overstatements
Reperformance
Auditor independently performs procedures or controls that were originally performed as part of an entity’s internal control
Reconciliation
Substantiates the existence and valuation of accounts
Observation
Auditor looks at a process or procedure performed by others
Tracing
Directional testing which looks for coverage in the opposite direction from vouching
Cutoff Review
Review of year-end transactions, especially inventory, cash, purchases, sales, and accruals
Auditing related accounts simultaneously
Certain accounts can be audited simultaneously, such as long-term liabilities and interest expense, capital additional to plant and equipment and repairs and maintenance expense, investments and dividend and interest income
Representation letter
Must obtain a management representation letter from the client
Subsequent events review
Required to perform certain procedures for the period after the balance sheet date of the auditor’s report
Relevant assertions: Account balances (CVER)
Completeness: all that should’ve been recorded have been
Valuation, Allocation, and Accuracy: recorded fairly and at appropriate amounts
Existence and Occurrence: assets, liabilities, and equity interests exist
Rights and Obligations: entity holds or controls the rights to assets and liabilities are the obligations of the entity
Relevant assertions: Transactions and Events (COVEU)
Completeness: all that should’ve been recorded have been Cutoff: transactions and events have been recorded in the correct period
Valuation, Allocation, and Accuracy: amounts and other data relating to recorded transactions and events have been recorded appropriately
Existence and Occurrence: transactions and events that have been recorded have occurred and pertain to the entity
Understandability and Classification: transactions and events have been recorded in the proper accounts
Relevant assertions: Presentation and Disclosure (CVRU)
Completeness: all disclosures that should have been included in F/S are included
Valuation, Allocation, and Accuracy: financial information and other information are fairly and at appropriate amounts
Rights and Obligations, and Occurrence: disclosed events and transactions have occurred and pertain to the entity
Understandability and Classification: financial information is appropriately presented and described and disclosures are clearly expressed
Auditing procedures to test completeness
Tracing, analytical review, observation
Auditing procedures to test cutoff
Cutoff procedures
Auditing procedures to test valuation/allocation/accuracy
Inspection, footing, independent recalculation, reconciliation
Auditing procedures to test existence and occurrence
Confirmation, observation, inspection, examination, vouching
Auditing procedures to test rights and obligations
Inspection
Auditing procedures to test understandability and classification
Inspection, review, inquiry of management
Revenue cycle: biggest audit concern
overstatement of revenues and assets
Revenue cycle: fraud risks
early revenue recognition, holding books open past the close of the accounting period, fictitious sales, failure to record sales returns, overstatement of receivables
Revenue cycle: I/C sales segregation of duties
- sales order prep
- credit approval
- shipment
- billing
- accounting
Revenue cycle: I/C A/R segregation of duties
- sales
- collection of cash receipts
- uncollectible receivables
- sales returns
- sales discounts
Revenue cycle: I/C cash receipts segregation of duties
- incoming mail opened by person who does not have access to the accounts receivable ledger
- receipts listed in detail with one copy and actual receipt sent to cashier to prep bank deposit
- another copy sent to a/r dept for entry to a/r records
- third copy sent to accounting dept for entry to general ledger a/r control account
Positive confirmations are best used when…
- large dollar amounts
- expect errors/disputes
- weak internal control
Negative confirmations are best used when…
- low risk
- small balances
- expect customer attention
Expenditure cycle: biggest audit concern
understatement of expenses and liabilities
Expenditure cycle: I/C purchases segregation of duties
- purchase requisition
- purchase orders
- receipt of goods or services
Expenditure cycle: I/C A/P segregation of duties
- recording the payable
2. approving invoice for payment and recording payment
Expenditure cycle: I/C cash disbursements segregation of duties
Functions of approving the payment and signing the checks should be segregated. Treasurer prepares, signs, mails checks and cancels all supporting documents after payment.
Cash cycle: fraud risk
lapping and kiting
Cash cycle: fraud risk – lapping
theft of cash concealed by failing to account for cash receipts
Cash cycle: fraud risk – kiting
occurs when a check drawn on one bank account is deposited in another bank and no record is made of the disbursement in the balance of the first bank
Cash cycle: I/C segregation of duties
- Close consideration of check-writing authority
2. separation of cash handling, record keeping, and reconciliation of bank statements
Inventory cycle: I/C segregation of duties
- purchasing
- receiving
- warehouse
- shipping
Investment cycle: biggest audit concern
overstatement of assets and income
Investment cycle: I/C segregation of duties
- authorization of purchase or sale
- custodian duties
- maintenance of the detailed record of investments
Investment cycle: custodian/=/ 3rd party
Should be kept in a safe deposit box. Should be periodically counted by party not associated with investments
PP&E cycle: major transactions
Purchases, repairs and maintenance, depreciation, disposal, revaluation and leasing
PP&E cycle: I/C segregation of duties
- acquisition
- subsidiary ledgers
- physical security
- written policies
- disposition
Payroll and Personnel cycle: audit risk
understatement of expenses and liabilities, creation of fictitious employees and the falsification of hours worked
Payroll and Personnel cycle: I/C segregation of duties
- authorization to employ and pay
- supervision
- timekeeping and cost accounting
- payroll check preparation
- check distribution
Financing cycle: I/C over debt
- adequate documentation of all financing agreements
- authorization of new debt financing
- detailed records of LT debt, including interest and principal payments
Financing cycle: I/C over equity
All stock issuances, dividend declarations , and treasury stock purchases must be authorized by the BOD
Related party transactions – audit risk
accuracy and completeness
What is an auditor’s responsibility regarding related party transactions?
To identify any related party transactions encountered during the course of the audit and for determining whether the transactions have been properly accounted for and disclosed in the F/S
Related party transactions – audit objectives
- recognize fraud risk factors
- conclude whether F/S achieve fair presentation
- obtain sufficient appropriate audit evidence about whether related party transactions and relationships have been appropriately identified, accounted for, and disclosed
Specific procedures to determine material transactions with related parties include
- evaluating the company’s controls
- asking management for the names of all related parties
- reviewing the reporting entity’s filings with the SEC
- reviewing material transactions for related party evidence
- reviewing prior years’ audit documentation or inquiring of the predecessor auditor
Items that are indicative of a related party transaction include…
- compensating balance arrangements
- loan guarantees
- unusual, nonrecurring transactions near year-end
- transactions based on terms that differ significantly
- nonmonetary exchanges
Previously unidentified/undisclosed RP trans – auditor’s responsibilities
- communicate info to other members of engagement team
- request mgt to identify all trans with the identified Rps
- inquire why entity’s controls failed to enable identification and disclosure of the RP
- perform appropriate substantive procedures
- reconsider risk that other RPs or RP trans may not have been identified/disclosed
- evaluate audit implications if mgt’s nondisclosure appears intentional
Accounting estimates – auditor’s responsibilities
- evaluate the degree of estimation uncertainty
- assess mgt’s written policies and practices
- verify that all material estimates have been developed
- determine that the accounting estimates are reasonable
- ensure that the accounting esitmates are properly presented and disclosed in conformity with GAAP
How does an auditor identify contingencies
- review the minutes
- review invoices from lawyers
- review correspondence from taxing authorities
- review bank confirmations for hidden bank loans
- discuss LT purchase commitments
- review status of LT leases
- discuss sales contracts
- review the interim F/S
- obtain a client rep letter
- send inquiry letter to client’s attorneys
Who prepares the letter of inquiry to client’s attorneys?
Management prepares and it is sent by the auditors
A lawyer’s refusal to respond to the letter of inquiry…
Is sufficient to preclude an unmodified opinion if the attorney has devoted substantial attention to litigation matters. This is a scope limitation.
Client’s refusal to permit inquiry of the attorneys…
Will result in a disclaimer of opinion or withdrawal from the audit
The purpose of applying analytical procedures during the overall review stage is to…
Evaluate the overall F/S presenation, to assess the conclusions reached, and to assist in forming an opinion on whether the F/S as a whole are free of material misstatement
“Clearly trivial”
Matters that are clearly trivial are inconsequential, both individually and in aggregate, and when judged by any criteria of size, nature or circumstance
Misstatements are more likely to be considered material if they…
- affect trends of profitability
- affect the entity’s compliance
- increase mgt compensation
- affect significant F/S elements
- can be objectively determined
- affect segment info
- misclassify between certain account balances
- are significant relative to needs of users
- are costly to correct
All misstatements should be communicated…
on a timely basis with the appropriate level of management
General documentation requirements
- The amount below which misstatements are clearly trivial
- All misstatements accumulated during audit and whether they have been corrected
- Auditor’s conclusion about whether uncorrected misstatements are material, individually/aggregate, and basis for that opinion
Documentation of uncorrected misstatements should include…
- aggregate effect on the F/S
- evaluation of whether the materiality levels have been exceeded
- effect of uncorrected misstatements on key ratios or trends and compliance.
A review consists of consideration whether:
- work performed in accordance with professional standards/laws/regs
- significant findings need further consideration
- appropriate consultations have taken place/have been documented and implemented
- NET is appropriate
- work performed supports conclusions reached
- evidence obtained is sufficient/appropriate
- objectives of engagement achieved
The engagement partner should review…
Critical areas of judgment, significant risks, other areas the engagement partner considers important
Review documentation requirements
- who performed the work/date completed
2. who reviewed audit documentation/date of review
An engagement quality reviewer must…
- evaluate significant judgments
- evaluate assessment of/responses to significant risks
- evaluate significant judgments about materiality, corrected and uncorrected misstatements, and control deficiencies
- review the firm’s independence
- review the engagement completion document
- review the F/S, mgts report on I/C and the engagement report
- read other information to be filed with the SEC
- evaluate communications with mgt
A significant engagement deficiency exists when…
Engagement team failed to obtain sufficient appropriate audit evidence, reached an inappropriate overall conclusion, engagement report is not appropriate for the circumstances, or the firm is not independent.
Working capital
current assets – current liabilities
Current ratio
current assets / current liabilities
Acid-test “quick” ratio
cash equivalents + marketable securities + accounts receivable / current liabilities
Cash ratio
cash equivalents + marketable securities / current liabilities
A/R turnover
net credit sales / average net receivables
A/R turnover in days
365 days / receivable turnover
Inventory turnover
COGS / average inventory
Inventory turnover in days
365 days / inventory turnover
Operating cycle
A/R turnover in days + inventory turnover in days
Working capital turnover
Sales / avg working capital
Total asset turnover
net sales / avg total assets
A/P turnover
Purchases / avg accounts payable
Days in A/P
365 days / accounts payable turnover
Net profit margin
net income / net sales
Return on total assets
net income / avg total assets
Return on assets
Net profit margin x total asset turnover
Return on Investment
Net income + interest expense (1-TR) / avg (LT liabs + equity)
Return on common equity
Net income – preferred dividends / avg common equity
Net operating margin %
Net operating income / net sales
Gross (profit) margin %
Gross (profit) margin / net sales
Operating cash flow per share
Operating cash flow / common shares outstanding
Degree of financial leverage
Earnings before interest and taxes / earnings before taxes
Earnings per share
Net income – preferred dividends / weighted avg # of common shares outstanding
Price/earnings ratio
Market price per share / diluted earnings per share
Dividend payout ratio
Dividends per common share / diluted earnings per share
Dividend yield
Dividends per common share / market price per common share
Book value per share
Total S/E – preferred stock / # of common shares outstanding
Debt/Equity
Total liabs / common S/E
Debt ratio
Total liabs / total assets
Times interest earned
Earnings before taxes and interest / interest
Operating cash flow / total debt
Operating cash flow / total debt
