Audit Evidence

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1 For what is audit evidence needed?

1.1 Amounts and compliance with accounting standards

Auditors aim to say, with reasonable assurance that the financial statements do not contain material misstatements. If you remember, we have already emphasised that this means that the financial statements must show figures which are substantially true (think sufficiently accurate) and be presented fairly. To avoid misstatements:

• the calculation of the amounts
  

• their presentation and
  

• disclosure
  

must comply with the relevant accounting standard(s). A simple example of a misstatement through incorrect treatment is that of a bank loan repayable in 9 months but which is classified as a long-term liability. If a 5 year loan is repayable by instalments, the liability has to be split into current and non-current parts .

If the auditor is willing to give an assurance about the financial statements then the auditor needs evidence that supports both the amount and its proper treatment under the accounting standards.

Evidence should be NEAT! Auditors:

1.2 Need Evidence for Amount and Treatment

The requirement to know what the accounting standards stipulate and how evidence about their application can be collected is a big change from AA to AAA.

Many of the ways of obtaining evidence that you will mention in AAA answers will be identical to those in AA (for example, tracing transactions to original documentation, inspecting assets). However, because AAA tends to deal with more difficult audit challenges, often where matters are not clear-cut and judgement is required, the following sources of evidence tend to be more important than they were in AA questions:

• Inspect board minutes: you would expect material and difficult matters to be discussed at board meetings.
  

• Ensure that the matter is included in the letter or representation.
  

• Ask to see impairment reviews that have been prepared by management and examine these critically.
  

• Raise enquiries with management.
  

• Inspect correspondence with third parties, such as lawyers.
  

• Examine post period end events: trading levels, prices, use of assets, resolution of disputes etc.
  

2 The assertions

Even if we just consider the auditing of the amounts items in the financial statements figure it is important to understand what an amount is asserting (saying or proclaiming). Every figure in the statement of financial position or in the statement of profit or loss (or other documents making up the financial statements) asserts (or says) a number of things. For example, a figure of $4m for machinery in non-current assets implies that:

• The amount is accurate
  

• It does relate to machinery
  

• The assets exist
  

• The machinery is owned
  

• The assets are appropriately valued
  

• All amounts have been included
  

The single figure is asserting all of this and evidence is needed for each assertion each figure makes.

ISA 315 states:

“…management…makes assertions regarding the recognition, measurement and presentation of classes of transactions and events, account balances and disclosures. Assertions used by the auditor to consider the different types of potential misstatements that may occur fall into the following two categories: ...”

Note the assertions that are the same (in red) for both categories.

3 Gathering audit evidence

The procedures for obtaining audit evidence are:

• Analytical procedures (ratios, changes and comparatives)
  

• Enquiry and confirmation. For example, asking the directors if they intend to sell or close down any part of the business.
  

• Inspection. For example, the physical condition of inventories or non-current assets.
  

• Observation. For example, watch what staff do in the warehouse as deliveries are received.
  

• RecalcUlation and re-performance. For example, recalculate the profits recognised on a construction contract to ensure its accuracy.
  

You might remember that these five procedures can be remembered by the vowels, A, E, I, O and U.

4 Analytical procedures

Analytical procedures are used to evaluate plausible relationships between financial and non-financial data including, calculating ratios and then comparing the amounts and ratios to:

• Last year’s results
  

• Budgets
  

• Industry standards
  

Also the trends and changes in the company’s financial statements over time will be examined.

You should recollect from your earlier studies that analytical procedures may be applied at three stages of the audit:

• Planning - this is a requirement (ISAs 300 & 315)
  

• Substantive procedures - this is optional (ISA 520)
  

• Final review - this is a requirement when forming an overall conclusion (ISA 520)
  

Performing substantive analytical procedures does not mean, for example, comparing two amounts, asking management why there is a difference and concluding that the explanation is reasonable. Yes, a comparison will be made, but the auditor must be able to:

• “develop an expectation …” – this must be based on verifiable data and plausible relationships
  

• which is “sufficiently precise to identify material misstatement” – this may require the disaggregation of data
  

• “determine the amount of any difference (between recorded amount and expectation) that is acceptable without further investigation” – the maximum acceptable difference (‘threshold’) may be a numerical amount or a % of the item being tested.
  

So, for example, the number of employees in a work force, the hours they work and their rates of pay are verifiable, and the auditor calculates an expected payroll cost of $690,00. The auditor determines 5% to be the threshold. This expectation is then compared with the reported payroll cost, say it is $720,000. The difference, $30,000 is 4.2%. This provides sufficient evidence without any need to perform tests of detail on the payroll. Another example is depreciation expense.

5 Sufficient, appropriate audit evidence

This is assumed knowledge from your earlier studies.

ISA 500 states that there should be:

• Sufficient
  

• Appropriate
  

audit evidence, to be able to draw reasonable conclusions on which to base an audit opinion.

Sufficient concerns the quantity of audit evidence.

Appropriate concerns the quality of audit evidence - its relevance and reliability. With respect to the reliability of audit evidence , remember the general 'rules of thumb':

• External evidence is better than the entity's records.
  

• Evidence obtained directly by the auditor is better than evidence passed on by the clients.
  

• Audit evidence is better if there is a sound system of internal control.
  

• Written evidence is much better than oral.
  

• Originals are better than photocopies.
  

For AAA, as well as being able to describe audit procedures (as for AA), you will be expected to be able to "evaluate ... if sufficient and appropriate audit evidence has been obtained".