Audit Evidence and Audit Testing

Chapter 6 Audit Evidence and Audit Testing

LEARNING OBJECTIVES

1.       Understand the nature of audit evidence and the factors affecting its persuasiveness.
2.       Describe the procedures for obtaining audit evidence.
3.       Discuss different types of audit tests and their relationship.
4.       Explain the nature and purposes of analytical procedures in different phases of audit.
5.       Apply analytical procedures on financial data.

1. Audit Evidence (審計證據)

1.1 Nature of audit evidence

1.1.1	Audit evidence
	Audit evidence is the information obtained by the auditors in arriving at the conclusions on which the audit opinion is based. (是指註冊會計師為了得出審計結論、形成審計意見而使用的所有資訊，包括財務報表依據的會計記錄中含有的資訊和其他資訊。)

1.1.2    Audit evidence comprises source documents, accounting records and corroborating (確證) information from both internal and external sources. Audit evidence is accumulated from an appropriate mix of tests of control and substantive tests.
1.1.3    Every auditor has to determine the appropriate type and amount of audit evidence to accumulate to be satisfied that the client’s financial statements are fairly presented. This judgement is important because cost of examining and evaluating all available evidence is too high. The auditor’s decisions on evidence accumulation involve the following aspects.
(a)        Audit procedure
In deciding which audit procedures are to be used, it is common to put them down in sufficiently specific terms to be used as instructions during the audit.
(b)        Sample size
Once the audit procedure is selected, it is possible to vary the sample size from one to all the items in the population being tested. The sample size for any given procedure is likely to vary from different audit assignments.
(c)        Items to be selected
After the sample size has been determined for an audit procedure, it is still necessary to decide which items in the population are to be tested.
(d)        Timing
An audit of financial statements usually covers a period such as a year, and an audit is usually not completed until several weeks or months after the end of the period. The timing of audit procedures can therefore vary from early in the accounting period to long after it has ended.

1.2 Characteristics of quality of audit evidence

1.2.1 HKSA 500 states that the auditor should obtain “sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion”.

1.2.2

Definition

Sufficiency (充分性) and appropriateness (適當性) are interrelated and apply to both tests of controls and substantive procedures.
(a) Sufficiency is the measure of the quantity of audit evidence. (審計證據的充分性是對審計證據數量的衡量，主要與註冊會計師確定的樣本量有關。)
(b) Appropriateness is the measure of the quality or reliability of the audit evidence. (審計證據的適當性是對審計證據品質的衡量，即審計證據在支援各類交易、帳戶餘額、列報（包括披露，下同）的相關認定，或發現其中存在錯報方面具有相關性和可靠性。)

1.2.3    The auditor’s judgement as to what is sufficient appropriate audit evidence is influenced by a number of factors.
(a)        Experience from previous audit including knowledge of business;
(b)        The degree of audit risk which results from the assessment of inherent risk and control risk;
(c)        The persuasiveness (証據的說服力) of the evidence which depends on the source and reliability of the available information;
(d)        Materiality of the item involved; and
(e)        Results of audit procedures.
1.2.4    Reliability of evidence                                                                                      (Jun 10)

QUALITY OF EVIDENCE
External	Audit evidence from external sources is more reliable than that obtained from the entity’s records.
Auditor	Evidence obtained directly by auditors is more reliable than that obtained by or from the entity.
Entity	Evidence obtained from the entity’s records is more reliable when accounting and internal control system operates effectively.
Written	Evidence in the form of documents or written representation are more reliable than oral representations.
Originals	Original documents are more realistic than photocopies, or facsimiles.

1.3 Factors affecting the persuasiveness of audit evidence

1.3.1    The factors are as follows:
(a)        Competence of evidence
Competence or reliability of evidence refers to the degree to which evidence can be considered believable.
(b)        Relevance to the audit objective
Audit evidence must be relevant to the audit objective that the auditor is testing before it can be reliable. Relevance should be considered in terms of specific audit objectives.
(c)        Timeliness
For example, evidence obtained from physical inventory count is usually more reliable for balance sheet value when it is obtained as close to the balance sheet date as possible.
(d)        Sufficiency of evidence – it is measured primarily by:
(i)         adequate sample size
(ii)        appropriate sampling method – samples containing large value items, high likelihood of misstatements, and representative to the population are usually considered to be sufficient.

1.4 Financial statement assertions

1.4.1    Financial statement assertions are the representations by management, explicit or otherwise, that are embodied in the financial statements, as used by the auditor to consider the different types of potential misstatements that may occur.
1.4.2    In other words, financial statement assertions are management’s explanation about the recognition, measurement, presentation and disclosure of information in the financial statements.
1.4.3    Financial statement assertions contained:

Assertions	Descriptions
Existence	An asset or liability exists at a given date.
Rights and obligation	An asset or liability pertains (屬于) to the entity at a given date.
Occurrence	A transaction or event took place which pertains the entity during the relevant period.
Completeness	There are no unrecorded assets, liabilities, transactions or events, or undisclosed items.
Valuation	An asset or liability is recorded at an appropriate carrying value.
Presentation and disclosure	An item is disclosed, classified and described in accordance with the applicable reporting framework.

1.5 Methods (or procedures) of accumulating audit evidence
(Jun 09)
1.5.1 HKSA 500 states that the methods of collecting audit evidence include the followings:

Procedures	Explanation
Inspection of assets	Inspection of assets that are recorded in the accounting records confirms existence, give evidence of valuation, but does not confirm rights and obligations. Confirmation that assets seen are recorded in accounting periods gives evidence of completeness.
Inspection of documentation	Confirmation to documentation of items recorded in accounting records confirms that an asset exists or a transaction occurred. Confirmation that items recorded in supporting documentation are recorded in accounting records tests completeness. Inspection also provides evidence of valuation/ measurement, rights and obligations and the nature of items (presentation and disclosure). It can also be used to compare documents and confirm authorization. Documentary Evidence Tracing (追蹤) – establishing the completeness of transaction processing by following a transaction of forward through the accounting records. For example, comparing information on selected receiving reports to the purchases journals. Vouching (憑單核對証明) – establishing the existence or occurrence of recorded transactions by following a transaction back to supporting documents from a subsequent processing step (also referred to as “tracing back”). For example, comparing recorded purchase transactions in the purchases journal to supporting evidence such as invoices, paid cheques, and receiving reports.
Observation	Involves watching a procedure being performed (for example, attendance of stocktake by auditors).
Enquiries	Seeking information from client staff or external sources.
Confirmation	Seeking confirmation from another source of details in client’s accounting records, for example, confirmation from bank of bank balances.
Computations	Checking arithmetic of client’s records, for example, adding up ledger account.
Analytical procedures (分析性程序)	Compare the client’s gross profit margin with that of the industry average and investigate any significant differences between them.
Reperformance	The auditor’s independent execution of procedures or controls that were originally performed as part of the entity’s internal controls. For example, the checking of bank reconciliation prepared by client.

2.       Audit Procedures to Obtain Audit Evidence
(Jun 09)
2.1       The auditor obtains audit evidence by undertaking audit procedures to do the following:
(a)        Obtain an understanding of the entity and its environment to assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levels (risk assessment procedures).
(b)        Test the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level (tests of controls).
(c)        Detect material misstatements at the assertion level (substantive procedures).

Summary of Audit Procedures

Test Type	Nature	Purposes	Techniques	Results Evaluation
a. Risk assessment procedures	This refers to the audit procedures of obtaining an understanding of client’s entity and its environment on a continuous and dynamic process of collecting and analyzing information throughout the audit.	To support assessments of the risks of material misstatement.	Risk assessment procedures should be starting from inquiries of management regarding the financial reporting procedures and perform analytical procedures to identify possible misstatements and unusual transactions.	The auditor should identify and assess the risks of material misstatement at the financial statement level, and at the assertion level for classes of transactions, account balances, and disclosures.
b. Walk through test	The auditor takes a few transactions of each type and work through them.	To ensure a correct description and understanding of the system.	The test should be started from the initial of the transaction to the end of it.	Where there are discrepancies between the expected system and the test result, the auditor should consider whether: (i) it is an isolated case; or (ii) the expected system is actually not in operation.
c. Test of control	Tests of controls are concerned with how internal control policies or procedures are applied, the consistency of application during the period audited, and by whom they are applied	To obtain audit evidence about the effectiveness of the: (i) design of the accounting and internal control systems to prevent and detect the material misstatements; and (ii) operation of internal controls throughout the period.	(i) Make inquiries of appropriate client personnel. (ii) Examine documents, records, and reports for evidence of control procedures. (iii) Observe control related activities. (iv) Re-perform client control procedures.	If the test of control reveals that no exceptions have occurred, then the auditor is entitled to rely on the working of that control. If there are exceptions, the auditor should determine whether they are isolated cases. If the existence of weaknesses in the system is confirmed, the auditor should consider to identify and test any alternative controls.
d. Substantive test	Those tests of transactions and balances and review procedures are intended to detect material misstatements or to identify accounts likely to contain material misstatements.	To seek to provide audit evidence as to completeness, accuracy and validity of the information contained in the books of accounts or in financial statements.	(i) Tracing – trace from the source documents to the ledger and financial statements to ensure the completeness, validity and accuracy of the balance. (ii) Vouching – details of the accounting entries and ledger balances can be vouched to the supporting documents to ensure that every transaction recorded has valid evidence to support it.	(i) If the substantive test reveals that there is no exception found, then the auditor can conclude that the balance on the financial statements is fairly stated. (ii) If not, there may be material misstatement on the financial statements.

2.2       There are three types of substantive procedures:
(a)        Substantive test of transactions (交易業務實質性測試):
(i)         For example, search for the omission of recording purchases and creditors.
(ii)        The auditor focuses on finding monetary errors in the transactions, rather than deviations from controls.
(iii)       Substantive tests of transactions are very effective and can gather competent evidence; however, such tests are more time consuming and thus they are costly than analytical procedures, but are less costly than tests of details of balances.
(b)        Test of details of balances:
(i)         Focus on obtaining evidence directly about an account balance rather than the individual debits and credits comprising the balance.
(ii)        Involve the use of external documents, direct confirmations and documents generated by client for verifying the balances on the financial statements.
(iii)       But very time consuming and costly to perform.
(c)        Analytical procedures (分析性程序)
It uses methods such as comparison and relationship to assess whether the transaction and account balance appear reasonable.

Question 1
An auditor obtains audit evidence by performing audit procedures to draw reasonable conclusions upon which to base the audit opinion. There are three major types of audit procedures, namely risk assessment, tests of control, and substantive procedures.

Required:

(a)      What are the purposes of each category of the three major types of audit procedure mentioned above?                                                                                            (3 marks)
(b)      What are the relationships between the three major types of audit procedure mentioned above?                                                                                            (6 marks)
(c)      What are the three major types of substantive procedure? Elaborate and provide on example of each type for the auditing of a mortgage bank loan and the related expenses.                                                                                                          (6 marks)
(d)      Among the following procedures, which one will not be applied as a risk assessment procedures and which one will not be applied as a test of controls procedure?
(i)      Management inquiry
(ii)     Analytical procedures
(iii)    Inspection of documents
(iv)    Re-performance
(v)     Observation
(2 marks)
(e)      Identify three aspects an auditor may consider for the measurement and review of an entity’s financial performance.                                                                        (3 marks)
(HKIAAT PBE Paper III Auditing and Information Systems June 2009 Q2)

3. Analytical Procedures

3.1 Nature of analytical procedures

3.1.1    Analytical procedure means the analysis of significant ratios or trends including the investigation of fluctuations or inconsistent relationships with other relevant information or deviation from the expected amount.
3.1.2    In particular, analytical procedures involve:
(a)        comparison of the entity’s current year financial information with:
(i)         prior period’s information.
(ii)        anticipated results such as budgets, forecasts and expectation of auditors.
(iii)       information of same industry.
(b)        consideration of relationships between or among:
(i)         financial statement elements that would have a predictable pattern.
(ii)        financial information and other relevant non-financial information.

3.2       Reasons (or purposes) for applying analytical procedures
(Dec 14)
3.2.1    HKSA 520 Analytical Procedures states that it is necessary for an auditor to apply analytical procedures as risk assessment and in the overall review at the end of the audit. It is expected that the analytical procedures can assist the auditor in the following aspects:
(a)        To identify areas where there are high risks of misstatements in the account balances.
(b)        Analysis of relationship between items of financial data and identification of any inconsistencies among them.
(c)        Comparison between current data with the data predicted and information from the pervious period and investigation of the variances.
(d)        Evaluation of the results in light of other audit evidence obtained.

3.3       Areas of application
(Dec 14)
3.3.1    Risk assessment procedures:
(a)        It can apply for obtaining an understanding of the entity and its environment and so the risk of possible material misstatements can be identified.
(b)        The results of risk assessment are also used for determining the nature, timing and extent of the other audit procedures.
(c)        Analytical procedure is useful for risk assessment in the following aspects:
(i)         Indicate critical aspects or risk areas of client’s business so as to identify the existence of unusual transactions and amount, ratios and trends that might have audit implications.
(ii)        Identify factors which have material effects on the financial statements and consider their relationship.
(iii)       Predict the values of individual items and compare them with actual amounts on management account and investigate the causes of any variances.
3.3.2    Substantive procedures at the execution stage:                                              (Dec 14)
Use as a substantive procedure when its use can be more effective or efficient than tests of details in reducing detection risk.
(a)        Assess the level of assurance of information from analytical review.
(b)        Make comparison between periods and investigate variances.
(c)        Extend the testing where evidence obtained by analytical procedure is inconsistent with evidence from other sources.
(d)        Reduce the tests of details where the results of analytical procedures indicate a lower risk of material misstatements.
3.3.3    Overall review of financial statements at the end of the audit:                    (Dec 14)
(a)        Forming an overall conclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity.
(b)        Identifying possible misstatements of classes of transaction and account balances by ratio analysis and trend analysis.
(c)        Assessing whether the entity is a going concern.
(d)        Identifying a previously unrecognized risk of material misstatement.

3.4 Factors to consider when applying analytical procedures

3.4.1    The auditor should consider the following factors:
(a)        Plausibility and predictability of the relationship identified for comparison and evaluation;
(b)        Objectives of analytical procedures and the extent to which their results can be relied upon;
(c)        Nature of the entity and the degree to which information can be decomposed;
(d)        Availability of information, both financial and non-financial;
(e)        Reliability of the information available;
(f)        Relevance of the information available;
(g)        Comparability of the information available;
(h)        Source of information available;
(i)         Knowledge gained during previous audits, together with the auditor’s understanding of the effectiveness of the accounting and internal control systems and the types of problems that in prior periods have given rise to accounting adjustments.

3.5 Advantages and limitations of analytical procedures

3.5.1    Advantages:
(a)        It can address several financial statements assertions at once.
(b)        It can corroborate with other audit evidence. By using analytical procedures auditors identify unusual items that can then be further investigated to ensure that a misstatement doesn’t exist in the balance.
3.5.2    Limitations:
(a)        It will be difficult to create an expectation if operations are significantly different from last year.
(b)        It will be difficult to use analytical procedures if there have been lots of one-off events in the year as there will be nothing to compare with them.

Question 2
“Auditors should apply analytical procedures at the planning and overall review stages of the audit.”

In addition to analytical procedures, auditors can obtain audit evidence using other types of audit procedures.

Required:
a.      What is the meaning of “analytical procedures”?                                             (2 marks)
b.      What are the purposes of using analytical procedures?                                    (3 marks)
c.      How can analytical procedures assist the auditors in each of the following items?
(i)      Understanding the client’s industry and business;
(ii)     Assessment of entity’s ability to continue a going concern; and
(iii)    Indication of the presence of possible misstatements in the financial statements.
(6 marks)
d.      State FIVE factors that auditors would consider when planning to perform analytical procedures as substantive procedures.                                                              (5 marks)
e.      State the shortcoming of the analytical procedure of comparing the account balance of the current year with the account balance of the previous year. Name another analytical procedure that can overcome this shortcoming.                                               (2 marks)
f.       Give TWO types of audit procedures, other than analytical procedures, that can enable auditors to obtain audit evidence.                                                                     (2 marks)
(Total 20 marks)

Question 3
Zak Co sells garden sheds and furniture from 15 retail outlets. Sales are made to individuals, with income being in the form of cash and debit cards. All items purchased are delivered to the customer using Zak’s own delivery vans; most sheds are too big for individuals to transport in their own motor vehicles. The directors of Zak indicate that the company has had a difficult year, but are pleased to present some acceptable results to the members.

The income statements for the last two financial years are shown below:

Income statement

	31 March 2008	31 March 2007
	$000	$000
Revenue	7,482	6,364
Cost of sales	(3,520)	(4,253)
Gross profit	3,962	2,111
Operating expenses
Administration	(1,235)	(1,320)
Selling and distribution	(981)	(689)
Interest payable	(101)	(105)
Investment income	145
Profit/(loss) before tax	1,790	(3)

Balance sheet extract
Cash and bank	253	(950)

Required:

As part of your risk assessment procedures for Zak Co, identify and provide a possible explanation for unusual changes in the income statement. (9 marks)
(ACCA F8 Audit and Assurance June 2008 Q3(b)

4. Use the Work of Other Experts

4.1       It is possible that an auditor’s expert may be needed to assist the auditor in one or more of the following:
(a)        Obtaining an understanding of the entity and its environment, including its internal control.
(b)        Identifying and assessing the risks of material misstatement.
(c)        Determining and implementing overall responses to assessed risks at the financial statement level.
(d)        Designing and performing further audit procedures to respond to assessed risks at the assertion level, comprising tests of controls or substantive procedures.
(e)        Evaluating the sufficiency and appropriateness of audit evidence obtained in forming an opinion on the financial statements.
4.2       If expertise in a field other than accounting or auditing is necessary to obtain sufficient appropriate audit evidence, the auditor shall determine whether to use the work of an auditor’s expert by considering the following matters:                                                                    (Dec 11, Jun 14, Dec 14)
(a)        The nature, scope and objectives of that expert’s work.
(b)        The respective roles and responsibilities of the auditor and that expert.
(c)        The nature, timing and extent of communication between the auditor and that expert, including the form of any report to be provided by that expert.
(d)        The need for the auditor’s expert to observe confidentiality requirements.

Question 4
You are an audit manager of ABC & Co. You are responsible for the audit of SHE Limited which is a client of ABC & Co. ABC & Co has focused their attention on conducting cost-effective audits by having adequate planning for every audit.

SHE Limited owns many shopping arcades in Hong Kong and mainland China, all are used to earn rental income. A lot of resources are allocated to set up a good internal control system for the collection of rental income.

Required:

(a) Discuss the benefits of audit planning. (4 marks)
(b) SHE Limited adopts the fair value model for the accounting of the investment properties. The auditor has decided to use an expert’s services regarding the fair value of the investment properties.

What matters should be agreed between the auditors and auditor’s expert before commencement of service?                                                                              (6 marks)
(c)     Assess (high, medium or low), with reasons the inherent risk of material misstatement of the existence of SHE Limited’s investment properties.    (5 marks)
(d)    State the FIVE components of internal control.                                           (5 marks)
           (HKIAAT PBE Paper III Auditing and Information Systems December 2014 Q5)

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Audit Evidence and Audit Testing

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