Chapter 7--Audit Evidence

7-1 Audit Evidence Compared with Evidence in Other Professions

The chapter opens with a story that turned out unfavorably for the auditor--though on the face of it, the auditor may have been conscientious in his efforts. In Table 7-1, the author presents a comparison of evidence used in various professions--science, law and auditing. The dimensions of the comparison include the use of the evidence, the nature of the evidence used, the parties evaluating the evidence, the certainty of the conclusions, the nature of the conclusions, and the typical consequences of an incorrect conclusion.

7-2 Audit Evidence Decisions

A key decision the auditor must make is the appropriate types and amounts of evidence to draw conclusions regarding financial statements or internal control. You might suggest that all evidence available should be used--but unfortunately, the cost of sampling every piece of evidence in a population would be prohibitive. In practice, the profession of auditing often requires taking a sample, and then drawing a conclusion based on that sample.

There are four types of decisions that an auditor must make:

  1. Which audit procedures should be used?
  2. What sample size should be selected for the procedure?
  3. Which items should be selected from the population?
  4. When should the procedures be performed?

Each of these types of decisions is described briefly in your text, along with an example. Note how the example audit procedure is modified to include the sample size, specification of which items to choose, and the timing of the sample.

A collection of audit procedures (each including sample sizes, items to choose and timing) is called an audit program. An example of an audit program appears in Table 13-4 in your text. As you might expect, a computerized version of an audit program can help the auditor organize the work.

7-3 What Makes the Evidence Persuasive?

If you review the Generally Accepted Audit Standards, you will find that the third standard of field work requires that the auditor to seek competent evidentiary matter. The evidence must be both competent and sufficient. Competence means that the evidence must be believeable or wothy of trust. The seven characteristics of competent evidence include:

  1. Relevance--to the audit objective that the auditor is testing;
  2. Independence of the provider--information received from outside the entity is presumed to be more reliable than from inside the entity.
  3. Effectiveness of the client's internal controls--evidence from a client whose internal controls are effective is more trustworthy.
  4. Auditor's direct knowledge--data or calculations prepared by someone inside the organization will not be as reliable as data computed or discovered by the auditor directly.
  5. Qualifications of the individuals providing the information--reliability of the information is enhanced if the person providing it is qualified to do so.
  6. Degree of objectivity--objective evidence is more reliable than evidence that is subjective.
  7. Timeliness--data that are timely for the purpose intended are considered more reliable.

Sufficiency of evidence refers to the quantity of evidence, In part, sufficiency relates to the sample size that the auditor selects, but the individual items selected for the sample may have a bearing as well. The relationships among competence and sufficiency characteristics are outlined in Table 7-2. The point is that, in order for the data to be persuasive, the auditor must take into account the combined effect of competence and sufficiency.

A final note in this section brings the important aspect of cost into the picture. The evidence must be persuasive in order to draw conclusions, but must also meet a cost constraint. The goal is to obtain sufficient evidence at the lowest possible cost.

7-4 Types of Audit Evidence

In deciding which procedures to use, the auditor may choose from seven different types of evidence:

  1. Physical examination--of a tangible asset such as inventory, cash, or fixed assets. Your text points out that some items, such as checks, are assets only during that period when they have inherent value; prior to execution and after cashing, checks are classified as documents. Physical examination is a way to verify that an asset exists, or to verify its condition, but not to determine whether the client owns the asset.
  2. Confirmation--is the receipt of a written or oral response from and independent third party verifying information requested by the auditor. Because of the independence of the third party, confirmations are a highly desirable, though costly, type of evidence. SAS 67 (AU 330) describes two types of confirmations. A positive confirmation asks the respondent to provide an answer in all circumstances, while a negative confirmation asks for a response only if the information is incorrect. As you might predict, negative confirmations are not as competent as positive confirmations. Note that SAS 67 requires confirmation of a sample of accounts receivable due to the materiality of receivables for most companies. Some typical types of information that auditors confirm are listed in Table 7-3. Note the proviso that confirmations must be under the control of the auditor for maximum reliability of the evidence.
  3. Documentation--consists of the client's business documents used to support accounting events. A strength of documentation is that it is prevalent and available at a low cost. Documents can be internal or externally generated. Internal documents provide less reliable evidence than external ones, particularly if the client's internal control is suspect. Documents that are external and have been prepared by qualified individuals such as attorneys or insurance brokers provide additional reliability. The use of documentation in support of a client's transactions is called vouching. It is important to note that electronic records are considered valid documents, per SAS 80.
  4. Analytical procedures--are comparisons of account balances and relationships as a check on reasonableness. Analytical procedures are required during the planning and completion phases of all audits and may be used for the following purposes: 1) to better understand the client's industry and business; 2) assess the client's ability to continue as a going concern; 3) to indicate the possibility of misstatements ("unusual fluctuations")in the client's financial statements; 4) to reduce the need for detailed audit tests
  5. Inquiries of the client directly from the auditor.
  6. Reperformance (rechecking) of samples of computations or information made by the client.
  7. Observation by the audtor during the course of the audit.

Table 7-4 brings together the seven types of evidence with the criteria to determine competence of the information. The author of your text draws the following conclusions from Table 7-4:

  1. The client's internal control has a significant impact on the competence of evidence.
  2. Physical examination and reperformance will likely be highly reliable if the client's internal control is strong.
  3. One type of evidence, by itself, is rarely sufficient to provide competence evidence.

Physical examination and confirmation are the two most expensive types of evidence, while documentation and analytical procedures are only moderately costly. Observation, inquiries of the client, and reperformance are the least costly type of evidence.

In Table 7-5, the text presents a sample of how different types of evidence could be gathered for a balance-related audit for inventory. Note the relationship among the audit procedure and the type of evidence gathered, as well as the sample size, items to select, and timing of the selection.

7-5 The Purposes of Audit Documentation

Audit documentation ("working papers") consists of the auditing procedures applied, evidence obtained, and conclusions reached in the engagement. The audit documentation is the auditor's evidence that the audit conforms to Generally Accepted Audit Standards, and is subject to review--by supervisors, or ultimately, by a court of law or regulatory agency.

Table 7-6 defines various auditing terms and provides examples of how the terms relate to auditing procedures and evidence gathered.

Audit documentation is the property of the auditor and is retained by the auditing firm at the conclusion of the audit. Client confidentiality must be maintained per Rule 301 of the Code of Professional Conduct, except in situations involving the subpoena of the auditor's records by a court of law, or as part of a state peer review.

The Sarbanes-Oxley Act requires that auditors retain audit working papers for a period of seven years, with severe penalties for willful destruction of such materials. The SEC also requires preservation of documentation supporting audit or review, including memos, correspondence, electronic records, etc. that were created, sent, or received in connection with the audit or review, as well as related materials containing conclusions, opinions, analyses or financial data. Note that email is not exempt from inclusion.

7-6 Preparing Organized Audit Documentation

Figure 7-2 presents an overview of the types of files and organization for a typical audit. The permanent files contain historical data pertinent to the current audit. Permanent files may include:

  1. Extracts of important company documents
  2. Analyses from previous years of accounts that have continuing importance
  3. Internal control information and information regarding control risk
  4. Results of analytical procedures from previous years' audits

Current files are pertinent to the current year's audit. Some typical inclusions are:

  1. The audit program for the current audit
  2. General information
  3. Working trial balance
  4. Adjusting and reclassification entries
  5. Supporting schedules

Pay particular attention to the section in your text entitled Preparation of Audit Documentation. The details of preparing audit documentation (dates, initials of preparer, indexing, cross-referencing, etc.) as well as a delineation of the work performed, footnotes, initialing of audit procedures, and conclusions reached are vital to an effective audit document.

7-7 Electronic Audit Evidence

Your text provides examples of computer programs that run in a Windows environment, that can be used to test evidence that are in a machine-readable format. Additionally, there is software available that can be used to manage the audit documentation and network sharing of files among the audit team.