Chapter 6 Audit Evidence

Chapter 6: Audit Evidence Sufficient: Appropriate:

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Enough evidence has to be obtained by the auditor to meet audit objectives, a major factor being the degree of confidence required.

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Reliable (evidence must be trustworthy. You will find, however, that there are many grades of evidence, some being more reliable of trustworthy than others. Relevant (evidence must be pertinent to the matter in hand, to a management assertion you wish to prove).

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Examples for sufficiency & appropriateness: If tests of quantity of inventory on hand reveal that stock records are accurate, the auditor will be able to reduce the number of stock items counted. On the other hand, if the quality of audit evidence is poor, obtaining more evidence will probably not give greater satisfaction to the auditor. For instance if the quality of information in the accounting records is low, extended analytical procedures are unlikely to give the audit evidence required. Paragraph 8 of ISA 500 addresses this matter when it notes that inspection of records and documents related to the collection of receivables after the period end may provide audit evidence regarding both existence and valuation, although not necessarily the appropriateness of period-end cut-offs. Another important point that auditors ordinarily find it necessary to rely on audit evidence that is persuasive rather than conclusive and that auditor therefore seeks evidence from different sources to support the same assertion. In other words, the auditor seeks corroborative evidence. This point is addressed in Paragraph 14 of ISA 500, which notes too that auditors are not satisfied with audit evidence that is less than persuasive. There is a link between persuasiveness and quantity as auditors seek to be persuaded that their objectives have been met by accumulating evidence. Auditor has to consider relevance and reliability as well as sufficiency of evidence. Although sample has to be large enough to be representative, it will only be reliable if it has been selected on a random basis, giving each item an equal chance of being selected. Auditors will be far more likely to accept that management assertions implied or otherwise, are true if they believe that management are competent and possess integrity. Evidence is the cornerstone of the audit process and it is a prerequisite for forming an opinion. Examples of specific assertions about trade debtors: Specific assertions about trade debtors  Trade debtors exist and owe the amounts stated in the debtor’s ledger to the company (this is basically a genuineness assertion).

Relevant evidence  Sales invoices supported by pre-numbered sales dispatch notes and  Sales orders combine with controls such as independent checking of completeness of dispatch notes and sales orders.  This would enhance the likelihood that credit sale are not only genuine, accurate and complete, trade debtors should also be genuine, complete and accurate, assuming that receipts from debtors had been properly recorded as well.

Trade debtors’ balances are fully collectible and if not, an appropriate provision for bad and doubtful debts has been made (this is an accuracy assertion). Paragraph 21 of ISA 500 states: Tests of controls are necessary in two circumstances. When the auditor’s risk assessment includes an expectation of the operating effectiveness of controls, the auditor is required to test those controls to support the risk assessment. In addition, when substantive procedures alone do not provide sufficient appropriate audit evidence, the auditor is required to perform tests of controls to obtain audit evidence about their operating effectiveness. 

Thus appropriate evidence in seeking to prove that controls over completeness of recording sales are adequate would be tests on the sequence of the numbering of the relevant documents. The only way that auditors can keep audit risk to acceptable proportions is to seek evidence to prove that management assertions are reasonable in the context of the subject of the audit. (1) Audit evidence is more reliable when it is obtained from independent sources outside the entity. For example, assume you are the auditor of a timber importation company and that the timber is held in bonded warehouses until required by the company for manufacture and sale. The auditor would normally regard a letter from the bonded warehouse company confirming that they hold the stocks of timber on behalf of your client as good evidence, provided that the warehouse company is of good reputation. Another example would be a letter from a bank manager confirming bank balances in the name of the client, overdraft limit, charges on company assets in the name of the bank and so on. “Evidence from independent sources outside the entity is more reliable, particularly when received from persons acting in a professional capacity.” (2) Audit evidence is more reliable when it exists in documentary form, whether in paper, electronic, or other medium (for example, a contemporaneously written record of a meeting is more reliable than a subsequent oral representation of the matters discussed). During an audit, the auditor will receive a wide variety of oral evidence from officials of the client. Much of this oral evidence will be reflected in the working papers of the auditor and this act of recording does have the effect of making the evidence more useful and more reliable. As a matter of policy audit firms should require staff members to record immediately in the working papers (whether computerized or manual) minutes of meetings held with the client’s staff. Some of the oral statements made by management will be included in a formal letter of representation from management to the auditor, thus putting this guidance of evidence into effect. An example of a representation would be, “There have been no legal cases affecting the company other than those of which you have been informed”. ISA 230 on audit documentation states that the auditor should document matter, which are important in providing audit evidence to support the auditor’s opinion, and evidence that the audit was carried out in accordance with ISAs. (3) Audit evidence provided by original documents is more reliable than audit evidence provided by photocopies or facsimiles. The reason for this is generalization is clear. It would be very easy to manipulate a photocopy or facsimile. (4) Evidence created in the normal course of business is better than evidence specially created to satisfy the auditor. Let us suppose that the auditor needs evidence to prove (say) that stocks held at the year-end have a NRV above cost. Up-to-date order books and market research reports, prepared for day-to-day use in the business, will provide the auditor with good evidence of saleability of stock. Such evidence will be better than evidence collected on an ad hoc basis. The point is of course, that information collected on a day-to-day basis is less likely to be biased than specially created evidence. For example, in the hotel industry, hotels clearly need to keep detailed records of occupancy for management purposes. This sort of information has to be accurate to that they can tell a potential customer if a room is available or not, and so they can tell which parts of the year need special rates to encourage visitors. It will have greater value than evidence produced ”just to satisfy the auditor”. (5) The best-informed source of audit evidence will normally be management of the company but management’s lack of independence reduces its value as a source of such evidence. Example: During the analytical review, an auditor notes that debtors represent 60 days sales in the current year compared with 45 days in the prior year and becomes concerned that this might indicate the need to increase the bad or doubtful debts provision. On enquiry, the chief accountant says that this is the result of a policy decision on the part of the directors, taken as a result of increased competition in the industry of which the company forms a part. The statement by the chief accountant is a good example of well-informed internal comment and one that the auditor would seek to corroborate. Possible sources of corroborative evidence might include: - Directors’ minutes of meeting at which the policy decision was taken. - Instructions issued on a routine basis to credit control staff in the company. - Commentaries in the financial press and trade press confirming the increased competition in the industry and the steps taken as a result. (6) Evidence about the future is particularly difficult to obtain and is less reliable than evidence about past events. Auditors frequently have to consider future events in the course of their duties. Examples of such events are: - Outcome of potential legal claims

- NRV of stocks - Collectability of debtors - Useful lives of fixed assets Although it may be more difficult for the auditor to obtain evidence about the future, its main feature being the uncertainty associated with it; there are ways in which the future may be made less cloudy. Generally speaking, the auditor’s view of future events, is likely to be coloured by their opinion of the reliability of management, the extent to which management has proved able to anticipate the future in the past and the means by which management itself attempts to control the future. Good companygenerated evidence about the future might include budgets for control purposes, forecasts of profits and up-to-date price lists for the post-balance sheet period. Other evidence about the future, which must be treated with great care, might include: - Government reports about the state of the economy - Comments by industry leaders - Reports in the trade and financial press (7) Evidence may be upgraded by the skilful use of corroborative evidence. We have already seen that other evidence may corroborate statements by client officials and that evidential material may be rendered more useful by the source from which it is derived being subjected to adequate control. The idea of upgrading of evidence is very important in the audit process, as, indeed, is the rejection of evidence as the result of downgrading. Corroborative evidence is evidence that is consistent with the data or information you have already collected. Analytical procedures involve the calculation of accounting ratios to examine patterns and trends and ensure that these are in line with expectations given the auditors’ knowledge of the organization. Analytical procedures can both identify areas, which need further examination and provide reassurance, in conjunction with other tests, that individual account balances are “correct”. Tests of controls determine whether the internal controls of the organization are operating as they are supposed to. Substantive tests (which can include analytical procedures) are designed to test the “correctness” of individual account balances by, for example, writing to (a sample of) the company’s trade debtors and asking them to confirm the outstanding balance of their account at the financial statement date. Important note: Auditors can rely on the good operation of controls to reduce the extent of their substantive procedures. This raises the possibility in very well run organizations of perhaps doing away with detailed tests altogether. Such a notion is tempting because typically substantive procedures are more costly for the auditor to perform than compliance tests. However, one can never obtain all the assurance from the tests of control because of the inherent limitations in any system of internal control, which include the following: - The cost of an internal control is not disproportionate to the potential loss. - Most systematic internal controls tend to be directed at routine transactions rather than non-routine transactions. - The potential for human error due to carelessness, distraction, mistakes of judgment and the misunderstanding of instructions. - The possibility that a person responsible for exercising an internal control could abuse that responsibility. - The possibility that procedures may become inadequate due to changes in conditions or that compliance with procedures may deteriorate over time. Because of these limitations, no system of internal control can ever completely remove the possibility of fraud or error from the financial statements. Therefore, some substantive testing will always be necessary. Financial Statement Assertions: 1) Accuracy

2) 3) 4) 5) 6) 7) 8) 9)

Completeness Cut off Authorization Classification Occurence Valuation & Allocation *Existence *Rights & Obligations