Ch-4 Audit evidence

Question 1

Reliability of audit evidence increases when

Answer 1

1. obtained from independent sources outside the entity.
2. the related controls imposed by the entity are effective.
3. obtained directly by the auditor
4. in documentary form, whether paper, electronic, or other medium,
5. obtained as original documents

Question 2

Auditor’s judgement as to sufficiency may be affected by the factors such as

Answer 2

a) Materiality
b) Risk of material misstatement
c) Size & characteristics of a population

Question 3

Audit procedures for obtaining audit evidence

Answer 3

Audit evidence to draw reasonable conclusions on which to base the auditor’s
opinion is obtained by performing:
(a) Risk assessment procedures; and
(b) Further audit procedures, which comprise:
(i) Tests of controls, when required by the SAs or when the auditor has chosen to do so; and
(ii) Substantive procedures, including tests of details and substantive analytical procedures.

Question 4

Audit procedures to obtain audit evidence can include:

Answer 4

(i) Inspection
(ii) Observation
(iii) External Confirmation
(iv) Recalculation
(v) Reperformance
(vi) Analytical Procedures
(vii) Inquiry

Question 5

Inspection

Answer 5

Inspection involves examining records or documents, whether internal or external, in paper form, electronic form, or other media, or a physical examination of an asset.

Question 6

Observation

Answer 6

Observation consists of looking at a process or procedure being performed by others

Question 7

External Confirmation

Answer 7

An external confirmation represents audit evidence obtained by the auditor as a direct written response to the auditor from a third party (the confirming party), in paper form, or by electronic or other medium.

Question 8

Recalculation

Answer 8

Recalculation consists of checking the mathematical accuracy of documents or records.

Question 9

Reperformance

Answer 9

Reperformance involves the auditor’s independent execution of procedures or controls that were originally performed as part of the entity’s internal control.

Question 10

Analytical Procedures

Answer 10

Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and non-financial data.

Question 11

Inquiry

Answer 11

Inquiry consists of seeking information from knowledgeable persons, both financial and non- financial, within the entity or outside the entity.

Question 12

What is Audit Trail ?

Answer 12

An audit trail is a documented flow of a transaction. It is used to investigate how a source document was translated into an account entry and from there it was inserted into financial statement of an entity. It is used as audit evidence to establish authentication and integrity of a transaction.

1. Audit trails (or audit logs) act as record-keepers that document evidence of certain events, procedures or operations, because their purpose is to reduce fraud, material errors, and unauthorized use.
2. Audit trails help to enhance internal controls and data security.
3. Audit trails can help in fixing responsibility, rebuilding events and in thorough analysis of problem areas.

Question 13

100% examination may be appropriate when,

Answer 13

• The population constitutes a small number of large value items;
• There is a significant risk and other means do not provide sufficient appropriate audit evidence; or
• The repetitive nature of a calculation or other process performed automatically by an information system makes a 100% examination cost effective.

Question 14

The auditor may decide to select specific items from a population. Specific items selected may include:

Answer 14

• High value or key items.
• All items over a certain amount.
• Items to obtain information.

Question 15

Relying on the work of a management’s expert

Answer 15

If the entity has employed or engaged experts, the auditor may rely on the works of experts, provided he is satisfied that sufficient and appropriate audit evidence is obtained with reasonable assurance to form an opinion on the financial statements.

the auditor shall
(a) Evaluate the competence, capabilities and objectivity of that expert;
(b) Obtain an understanding of the work of that expert; and
(c) Evaluate the appropriateness of that expert’s work as audit evidence for the relevant assertion.

Question 16

Definition of Internal Audit Function

Answer 16

A function of an entity that performs assurance and consulting activities designed to evaluate and improve the effectiveness of the entity’s governance, risk management and internal control processes.

Question 17

what are the Ways in which the external auditor may make use of the function for purposes of the audit.

Answer 17

the external auditor may make use of the internal audit function for purposes of the audit in one or more of the following ways:

(i) to obtain information that is relevant to the external auditor’s assessments of
the risks of material misstatement due to error or fraud.

(ii) Unless prohibited, or restricted to some extent, by law or regulation, the external auditor, after appropriate evaluation, may decide to use work that has been performed by the internal audit function during the period in partial substitution for audit evidence to be obtained directly by the external auditor.

(iii) Unless prohibited, or restricted to some extent, by law or regulation, the external auditor may use internal auditors to perform audit procedures under the direction, supervision and review of the external auditor (referred to as “direct assistance”).

Question 18

Objectives of the external auditor, where the entity has an internal audit function

Answer 18

(a) To determine whether the work of the internal audit function can be used, and if so, in which areas and to what extent;
(b) If using the work of the internal audit function, to determine whether that work is adequate for purposes of the audit; and
(c ) If using internal auditors to provide direct assistance, to appropriately direct, supervise and review their work.

Question 19

How can the external auditor determine whether the work of the internal audit function can be used for purposes of the audit.

Answer 19

by evaluating the following:
(A) The extent to which the internal audit function’s organizational status and relevant policies and procedures support the objectivity of the internal auditors;
(B) The level of competence of the internal audit function; and
(C) Whether the internal audit function applies a systematic and disciplined approach, including quality control.

Question 20

What are the circumstances When Work of the Internal Audit Function Cannot Be Used

Answer 20

The external auditor shall not use the work of the internal audit function if the external auditor determines that:

(a) The function’s organizational status and relevant policies and procedures do not adequately support the objectivity of internal auditors;

(b) The function lacks sufficient competence; or

(c ) The function does not apply a systematic and disciplined approach, including quality control.

Question 21

Give examples of work of the internal audit function that can be used by the external auditor

Answer 21

Examples of work of the internal audit function that can be used by the external auditor include the following:
1. Testing of the operating effectiveness of controls.
2. Substantive procedures involving limited judgment.
3. Observations of inventory counts.
4. Tracing transactions through the information system relevant to financial reporting.
5. Testing of compliance with regulatory requirements.

Question 22

What are the circumstances in which the external auditor shall plan to use less of the work of the Internal audit function and perform more of the work directly

Answer 22

The external auditor shall make all significant judgments in the audit engagement and, to prevent undue use of the work of the internal audit function, shall plan to use less of the work of the function and perform more of the work directly if:
(a) The more judgment is involved in:
(i) Planning and performing relevant audit procedures; and
(ii) Evaluating the audit evidence gathered;
(b) The higher the assessed risk of material misstatement at the assertion level, with special consideration given to risks identified as significant;
(c ) The less the internal audit function’s organizational status and relevant policies and procedures adequately support the objectivity of the internal auditors; and
(d) The lower the level of competence of the internal audit function.

Question 23

Read topic 2.10 and 2.11 on pg 4.40 to 4.43

Answer 23

ok

Question 24

Distinction between Internal Financial Control and Internal Control over financial reporting

Answer 24

The term Internal Financial Controls (IFC) refers to the policies and procedures put in place by companies for ensuring reliability of financial reporting, effectiveness and efficiency of operations, compliance with applicable laws and regulations, safeguarding of assets and prevention and detection of frauds.
On the other hand, Internal controls over financial reporting is required where auditors are required to express an opinion on the effectiveness of an entity’s internal controls over financial reporting, such opinion is in addition to and distinct from the opinion expressed by the auditor on the financial statements.
Therefore, “internal financial control” is a wider term where as “internal controls over financial reporting” is a narrower term restricted to entity’s internal controls over financial reporting only.

Question 25

Meaning of Audit Sampling

Answer 25

According to SA 530 “Audit sampling”, ‘audit sampling’ refers to the application of audit procedures to less than 100% of items within a population relevant under the audit, such that all sampling units (i.e. all the items in the population) have a equal chance of selection.

Question 26

What is population and what should be its characteristics ?

Answer 26

Population refers to the entire set of data from which a sample is selected and about which the auditor wishes to draw conclusions.

1. Appropriateness: The auditor will need to determine that the population from which the sample is drawn is appropriate for the specific audit objective. Appropriate means population from which the samples are drawn shall be relevant for the specific objective under audit. This is because when the samples are drawn, the audit procedures are applied on the sample and the conclusions are projected on the population.
   It is important for the auditor to ensure that the population is appropriate to the objective of the audit procedure, which will include consideration of the direction of testing.
2. Completeness: The population also needs to be complete, which means that if the auditor intends to use the sample to draw conclusions about whether a control activity is operated effectively during the financial reporting period, the population needs to include all relevant items i.e all the activities that form part of that relevant internal control, throughout the entire period. If population is complete in all respects, the conclusions drawn on the population will be considered to be reasonable.
3. Reliable: When performing the audit sampling, the auditor performs audit procedures to ensure that the information upon which the audit sampling is performed is sufficiently complete and accurate. Auditor should obtain evidence about the reliability of population. If population is not reliable with respect to accuracy and source, the sample drawn will definitely not be relevant for the specific audit objective.

Question 27

What are the factors that should be considered for deciding upon the extent of checking on a sampling plan ?

Answer 27

The factors that should be considered for deciding upon the extent of checking on a sampling plan are following:
(i) Size of the organisation under audit.
(ii) State of the internal control.
(iii) Adequacy and reliability of books and records.
(iv) Tolerable error range.
(v) Degree of the desired confidence.

Question 28

Sample Selection Methods

Answer 28

(1) Random Sampling
(2) Interval Sampling or Systematic Sampling
(3) Monetary Unit Sampling
(4) Haphazard sampling
(5) Block Sampling

Question 29

read SA 501

Answer 29

ok

Question 30

What are external confirmation procedures adopted by the auditor to obtain audit evidence ?

Answer 30

When using external confirmation procedures, the auditor shall maintain control over external confirmation requests, including:
(a) Determining the information to be confirmed or requested;
(b) Selecting the appropriate confirming party;
(c) Designing the confirmation requests, including determining that requests are properly addressed and contain return information for responses to be sent directly to the auditor; and
(d) Sending the requests, including follow-up requests when applicable, to the confirming party.

Question 31

If management refuses to allow the auditor to send a confirmation request, the auditor shall:

Answer 31

(a) Inquire as to management’s reasons for the refusal, and seek audit evidence as to their validity and reasonableness;
(b) Evaluate the implications of management’s refusal on the auditor’s assessment of the relevant risks of material misstatement, including the risk of fraud, and on the nature, timing and extent of other audit procedures; and
(c) Perform alternative audit procedures designed to obtain relevant and reliable audit evidence.

If the auditor concludes that management’s refusal to allow the auditor to send a confirmation request is unreasonable, or the auditor is unable to obtain relevant and reliable audit evidence from alternative audit procedures, the auditor shall communicate with those charged with governance in accordance with SA 260.
The auditor also shall determine the implications for the audit and the auditor’s
opinion in accordance with SA 705.

Question 32

The auditor shall obtain sufficient appropriate audit evidence about whether the opening balances contain misstatements that materially affect the current period’s financial statements by:

Answer 32

(a) Determining whether the prior period’s closing balances have been correctly brought forward to the current period or, when appropriate, any adjustments have been disclosed as prior period items in the current year’s Statement of Profit and Loss;

(b) Determining whether the opening balances reflect the application of appropriate accounting policies; and

(c) Performing one or more of the following:
(i) Where the prior year financial statements were audited, perusing the copies of the audited financial statements including the other relevant documents relating to the prior period financial statements;
(ii) Evaluating whether audit procedures performed in the current period provide evidence relevant to the opening balances; or
(iii) Performing specific audit procedures to obtain evidence regarding the opening balances.

If the auditor obtains audit evidence that the opening balances contain misstatements that could materially affect the current period’s financial statements, the auditor shall perform such additional audit procedures as are appropriate in the circumstances to determine the effect on the current period’s financial statements.
If the auditor concludes that such misstatements exist in the current period’s financial statements, the auditor shall communicate the misstatements with the appropriate level of management and those charged with governance.

Question 33

Definition of Related Party

Answer 33

A party that is either
(i) A related party as defined in the applicable financial reporting framework; or
(ii) Where the applicable financial reporting framework establishes minimal or no related party requirements:
a. A person or other entity that has control or significant influence, directly or indirectly through one or more intermediaries, over the reporting entity;
b. Another entity over which the reporting entity has control or significant influence, directly or indirectly through one or more intermediaries; or
c. Another entity that is under common control with the reporting entity through having:
i. Common controlling ownership;
ii. Owners who are close family members; or
iii. Common key management.

Question 34

What type of relationships indicate the presence of control or significant influence.

Answer 34

(i) Direct or indirect equity holdings or other financial interests in the entity.
(ii) The entity’s holdings of direct or indirect equity or other financial interests in other entities.
(iii) Being part of those charged with governance or key management (i.e., those members of management who have the authority and responsibility for planning, directing and controlling the activities of the entity).
(iv) Being a close family member of any person referred to in subparagraph (iii).
(v) Having a significant business relationship with any person referred to in subparagraph (iii).

Question 35

Meaning of control and significant influence in reference to related party

Answer 35

(a) Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities; and
(b) Significant influence (which may be gained by share ownership, statute or agreement) is the power to participate in the financial and operating policy decisions of an entity, but is not control over those policies.

Question 36

Many related party transactions are in the normal course of business. However, the nature of related party relationships and transactions may, in some circumstances, give rise to higher risks of material misstatement of the financial statements than transactions with unrelated parties. Give few examples of such areas.
or
The nature of related party relationships and transactions may, in some circumstances, give rise to higher risks of material misstatement of the financial statements than transactions with unrelated parties. Explain with the help of at least three examples.

Answer 36

Many related party transactions are in the normal course of business. In such circumstances, they may carry no higher risk of material misstatement of the financial statements than similar transactions with unrelated parties.
However, the nature of related party relationships and transactions may, in some circumstances, give rise to higher risks of material misstatement of the financial statements than transactions with unrelated parties.

for example
(A) Related parties may operate through an extensive and complex range of relationships and structures, with a corresponding increase in the complexity of related party transactions.
(B) Information systems may be ineffective at identifying or summarising transactions and outstanding balances between an entity and its related parties.
(C) Related party transactions may not be conducted under normal market terms and conditions; for example, some related party transactions may be conducted with no exchange of consideration.

Question 37

An auditor is appointed for the first time for audit of accounts of an entity. The accounts of previous year were unaudited. He is unable to obtain sufficient appropriate audit evidence regarding the opening balances. What is his responsibility in this regard?

Answer 37

1. If the auditor is unable to obtain sufficient appropriate audit evidence regarding the opening balances,
   the auditor shall express a qualified opinion or a disclaimer of opinion, as appropriate, in accordance with SA 705.
2. If the auditor concludes that the opening balances contain a misstatement that materially affects the current period’s financial statements, and the effect of the misstatement is not properly accounted for or not adequately presented or disclosed, the auditor shall express a qualified opinion or an adverse opinion, as appropriate, in accordance with SA 705.

Question 38

Discuss the objective of Auditor with respect to Opening balances in conducting an initial audit engagement.

Answer 38

In conducting an initial audit engagement, the objective of the auditor with respect to opening balances is to obtain sufficient appropriate audit evidence about whether:
(a) Opening balances contain misstatements that materially affect the current period’s financial statements; and
(b) Appropriate accounting policies reflected in the opening balances have been consistently applied in the current period’s financial statements, or changes thereto are properly accounted for and adequately presented and disclosed in accordance with the applicable financial reporting framework.

Question 39

M/s Pankaj & Associates, Chartered Accountants, have been appointed as an auditor of ABC Limited. CA Pankaj did not apply any audit procedures regarding opening balances. He argued that since financial statements were audited by the predecessor auditor therefore he is not required to verify them. Is CA Pankaj correct in his approach?

Answer 39

8. Initial audit engagement is an engagement in which either:
   (i) The financial statements for the prior period were not audited; or
   (ii) The financial statements for the prior period were audited by a predecessor auditor.

From the above, it is quite clear that CA Pankaj is not correct in his approach and therefore would be required to follow the initial audit engagement and also apply audit procedures regarding opening balances.

Audit Procedures regarding Opening Balances;

The auditor shall read the most recent financial statements, if any, and the predecessor auditor’s report thereon, if any, for information relevant to opening balances, including disclosures.

The auditor shall obtain sufficient appropriate audit evidence about whether the opening balances contain misstatements that materially affect the current period’s financial statements by:
(a) Determining whether the prior period’s closing balances have been correctly brought forward to the current period or, when appropriate, any adjustments have been disclosed as prior period items in the current year’s Statement of Profit and Loss;
(b) Determining whether the opening balances reflect the application of appropriate accounting policies; and
(c) Performing one or more of the following:
(i) Where the prior year financial statements were audited, perusing the copies of the audited financial statements including the other relevant documents relating to the prior period financial statements;
(ii) Evaluating whether audit procedures performed in the current period provide evidence relevant to the opening balances; or
(iii) Performing specific audit procedures to obtain evidence regarding the opening balances.

Question 40

How can an auditor verify the existence of related party relationships and transactions?

Answer 40

During the audit, the auditor should maintain alertness for related party information while reviewing records and documents. He may inspect the following records or documents that may provide information about related party relationships and transactions, for example:
1. Entity income tax returns.
2. Information supplied by the entity to regulatory authorities.
3. Shareholder registers to identify the entity’s principal shareholders.
4. Statements of conflicts of interest from management and those charged with governance.
5. Records of the entity’s investments and those of its pension plans.
6. Contracts and agreements with key management or those charged with governance.
7. Significant contracts and agreements not in the entity’s ordinary course of business.
8. Specific invoices and correspondence from the entity’s professional advisors.
9. Life insurance policies acquired by the entity.
10. Significant contracts re-negotiated by the entity during the period.
11. Internal auditors’ reports.
12. Documents associated with the entity’s filings with a securities regulator e.g,
prospectuses)

Question 41

What should the auditor do to understand Entity’s Related Party Relationships & Transactions

Answer 41

The auditor shall inquire of management regarding:
(a) The identity of the entity’s related parties, including changes from the prior period;
(b) The nature of the relationships between the entity and these related parties; and
(c) Whether the entity entered into any transactions with these related parties during the period and, if so, the type and purpose of the transactions.

Question 42

What are the factors to be considered for Substantive Audit Procedures

Answer 42

The auditor should consider the following factors for Substantive Audit Procedures:
i) Availability of Data – The availability of reliable and relevant data will facilitate effective analytical procedures.
ii) Disaggregation – The degree of disaggregation in available data can directly affect the degree of its usefulness in detecting misstatements.
iii) Account Type – Substantive analytical procedures are more useful for certain types of accounts than for others. Income statement accounts tend to be more predictable because they reflect accumulated transactions over a period, whereas balance sheet accounts represent the net effect of transactions at a point in time or are subject to greater management judgment.
iv) Source – Some classes of transactions tend to be more predictable because they consist of numerous, similar transactions, (e.g., through routine processes). Whereas the transactions recorded by non-routine and estimation SCOTs (Significant Classes of Transactions) are often subject to management judgment and therefore more difficult to predict.
v) Predictability – Substantive analytical procedures are more appropriate when an account balance or relationships between items of data are predictable (e.g., between sales and cost of sales or between trade receivables and cash receipts). A predictable relationship is one that may reasonably be expected to exist and continue over time.
vi) Nature of Assertion – Substantive analytical procedures may be more effective in providing evidence for some assertions (e.g., completeness or valuation) than for others (e.g., rights and obligations). Predictive analytical procedures using data analytics can be used to address completeness, valuation/measurement and occurrence.
vii) Inherent Risk or “What Can Go Wrong” – When we are designing audit procedures to address an inherent risk or “what can go wrong”, we consider the nature of the risk of material misstatement in order to determine if a substantive analytical procedure can be used to obtain audit evidence. When inherent risk is higher, we may design tests of details to address the higher inherent risk. When significant risks have been identified, audit evidence obtained solely from substantive analytical procedures is unlikely to be sufficient.

Question 43

What are techniques available as Substantive Analytical Procedures

Answer 43

The design of a substantive analytical procedure is limited only by the availability of reliable data and the experience and creativity of the audit team. Substantive analytical procedures generally take one of the following forms:
i) Trend analysis – Trend analysis is a commonly used technique. It is the comparison of current data with the prior period balance or with a trend in two or more prior period balances.
ii) Ratio analysis – Ratio analysis is useful for analysing asset and liability accounts as well as revenue and expense accounts.
iii) Reasonableness tests – Unlike trend analysis, this analytical procedure does not rely on events of prior periods, but upon non-financial data for the audit period under consideration. In other words these tests are made by reviewing the relationship of certain account balances to other balances for reasonableness of amounts.
iv) Structural modelling – A modelling tool constructs a statistical model from financial and/or non-financial data of prior accounting periods to predict current account balances (e.g., linear regression).

Question 44

Analytical Procedures used as Substantive Tests

Answer 44

When designing and performing substantive analytical procedures, either alone or in combination with tests of details, as substantive procedures in accordance with SA 330, the auditor shall:
(i) Determine the suitability of particular substantive analytical procedures for given assertions, taking account of the assessed risks of material misstatement and tests of details, if any, for these assertions;
(ii) Evaluate the reliability of data from which the auditor’s expectation of recorded amounts or ratios is developed, taking account of source, comparability, and nature and relevance of information available, and controls over preparation;
(iii) Develop an expectation of recorded amounts or ratios and evaluate whether the expectation is sufficiently precise to identify a misstatement that, individually or when aggregated with other misstatements, may cause the financial statements to be materially misstated; and
(iv) Determine the amount of any difference of recorded amounts from expected values that is acceptable without further investigation.

Question 45

How to ensure whether data is reliable for purposes of designing substantive analytical procedures:

Answer 45

(i) Source of the information available. For example, information may be more reliable when it is obtained from independent sources outside the entity;
(ii) Comparability of the information available. For example, broad industry data may need to be supplemented to be comparable to that of an entity that produces and sells specialised products;
(iii) Nature and relevance of the information available. For example, whether budgets have been established as results to be expected rather than as goals to be achieved; and
(iv) Controls over the preparation of the information that are designed to ensure its completeness, accuracy and validity. For example, controls over the preparation, review and maintenance of budgets.