Evidence Master Class

A guide to obtaining and evaluating audit evidence.

1. Audit Evidence: Sufficiency and Appropriateness

The auditor's objective is to obtain sufficient appropriate audit evidence to form an opinion. This means gathering enough evidence of high enough quality to draw a reasonable conclusion.

Sufficient Evidence

Sufficiency refers to the quantity of evidence. The auditor must gather enough evidence to form a conclusion, considering factors such as the risk of material misstatement, the materiality of the item, and the results of controls testing. This is a matter of professional judgment.

Appropriate Evidence

Appropriateness refers to the quality of the evidence, which is determined by its relevance and reliability.

  • Reliability: Evidence from an independent external source is more reliable than client-generated evidence. Evidence obtained directly by the auditor is more reliable than that obtained indirectly. Written evidence is more reliable than oral, and original documents are more reliable than copies.
  • Relevance: The evidence must relate to the specific financial statement assertion being tested. For example, inspecting a physical asset is relevant to existence, but not necessarily to its valuation.

2. Financial Statement Assertions

Assertions are management's representations about transactions, account balances, and disclosures in the financial statements. The auditor's job is to gather evidence to confirm these assertions are correct.

Assertions about Transactions and Events

  • Occurrence: Transactions and events actually happened.
  • Completeness: All transactions that should have been recorded have been recorded.
  • Accuracy: Amounts and other data have been recorded appropriately.
  • Cut-off: Transactions are recorded in the correct accounting period.
  • Classification: Transactions are recorded in the proper accounts.
  • Presentation: Transactions are clearly described and understandable.

Assertions about Account Balances

  • Existence: Assets, liabilities, and equity interests exist.
  • Rights and Obligations: The entity holds the rights to assets and is obligated for liabilities.
  • Completeness: All balances that should have been recorded have been recorded.
  • Accuracy, Valuation and Allocation: Balances are included at appropriate amounts.
  • Classification: Balances are recorded in the proper accounts.
  • Presentation: Balances are clearly described and understandable.

Exam Strategy: Linking Procedures to Assertions

A common exam requirement is to describe a procedure to test a specific assertion. You must be precise. For example, attending an inventory count and tracing items from the floor to the count sheet tests completeness. Tracing from the count sheet to the floor tests existence. Make sure your procedure directly addresses the assertion in question.

3. Sources of Audit Evidence

Auditors obtain evidence from two main types of procedures: tests of controls and substantive procedures.

Tests of Controls vs. Substantive Procedures

  • Tests of Controls: These procedures evaluate the effectiveness of the client's internal controls. They provide indirect evidence about the financial statements by confirming that the system is reliable.
  • Substantive Procedures: These procedures are designed to detect material misstatements at the assertion level. They can be broken down into tests of detail (e.g., inspecting a specific invoice) and substantive analytical procedures (e.g., analyzing relationships and trends).

Exam Strategy: Choosing the Right Test

In the exam, when you're asked to provide an audit procedure, be specific about what kind of test it is. For example, for tests of controls, you might say "Inspect a sample of invoices for evidence of authorization." For tests of detail, you might say "Inspect a sample of invoices and agree the amount to the general ledger." This shows you understand the purpose of each type of procedure.

4. Types of Audit Procedures

The auditor can use a combination of the following procedures to gather evidence:

  • Inspection: Examining records, documents, or physical assets. This provides evidence for assertions like existence (of assets) and rights and obligations (of documents like title deeds).
  • Observation: Watching a process or procedure being performed by others, such as an inventory count. This provides evidence that a control is operating at the time of observation.
  • External Confirmation: Obtaining a direct written response from an external third party, such as a bank or customer. This is a highly reliable source of evidence, especially for existence of balances.
  • Recalculation: Manually or electronically checking the arithmetical accuracy of documents and records.
  • Reperformance: The auditor's independent execution of procedures or controls that were originally performed by the client.
  • Analytical Procedures: Evaluating financial information through the analysis of plausible relationships.
  • Enquiry: Seeking information from knowledgeable persons. Responses should be corroborated with other evidence as they are considered a low quality source due to potential management bias.

5. Relying on the Work of Others

Auditors may rely on the work of others, such as experts, internal audit, and service organizations, to gather evidence. However, responsibility for the audit opinion remains with the external auditor.

Using an Expert

If the auditor lacks the necessary technical knowledge, they may use an auditor's expert (e.g., a valuer or actuary). Before relying on their work, the auditor must:

  • Evaluate the expert's competence, capabilities, and objectivity.
  • Agree on the nature, scope, and objectives of their work in writing.
  • Evaluate the appropriateness of the expert's findings by scrutinizing their work, assumptions, and source data.

Using Internal Audit

The auditor can rely on the work of a client's internal audit department, but only after assessing their objectivity, competence, and systematic approach. The external auditor must still reperform some of the internal audit's work to ensure its adequacy and should not delegate work requiring significant judgment.

Using Service Organizations

For functions handled by a service organization (e.g., payroll processing), the auditor must obtain evidence from them. This can be done by obtaining a Type 1 or Type 2 report from the service organization's auditor, which describes the design and effectiveness of their controls. The external auditor must assess the competence and independence of this auditor.

6. Selecting Items for Testing

Auditors have three methods for selecting items to test from a population:

  • 100% Testing: Used for small populations or high-risk items.
  • Specific Item Selection: Selecting items with specific characteristics, such as high-value items or all items over a certain amount.
  • Sampling: Applying audit procedures to less than 100% of a population, ensuring all items have a chance of selection. This is a common method for large populations.

Statistical vs. Non-Statistical Sampling

  • Statistical Sampling: Uses random selection and probability theory to evaluate results. Methods include random selection, systematic selection, and monetary unit sampling. This provides a more objective basis for drawing conclusions about the entire population.
  • Non-Statistical Sampling: Does not use random selection. Methods include haphazard selection (auditor avoids bias without a structured technique) and block selection (auditor tests a contiguous block of items).

Exam Strategy: Interpreting Sample Results

Be careful when an exam question gives you sample results. For deviations (in tests of controls), you're looking at the percentage of control failures. If this rate exceeds your tolerable deviation rate, you increase substantive testing. For misstatements (in substantive tests), you must project the misstatement found in the sample to the entire population. If the projected misstatement exceeds tolerable misstatement, you must extend the sample and perform more work. Don't confuse the two!

7. Automated Tools and Techniques (CAATs)

Automated tools and techniques, such as test data and audit software, enable auditors to test large volumes of data more efficiently and effectively. These tools are often referred to as CAATs (Computer-Assisted Audit Techniques).

  • Test Data: Involves submitting dummy data (with and without errors) into the client's system to test programmed controls. This provides direct evidence of the system's effectiveness.
  • Audit Software: Used to interrogate a client's system, enabling the auditor to perform tasks like extracting samples, recalculating figures, and identifying transactions with specific characteristics. This is especially useful for testing large populations.
  • Data Analytics: A more advanced form of audit software that analyzes patterns, deviations, and inconsistencies in large datasets. It can provide a deeper understanding of the client and may reduce the need for sampling by testing 100% of the data.

Test Your Understanding Questions and Solutions

Test your understanding 1

Question: List FOUR factors that influence the reliability of audit evidence.

Solution:

  • Evidence from an independent external source is more reliable than evidence generated internally.
  • Evidence obtained directly by the auditor is more reliable than evidence obtained indirectly.
  • Evidence in documentary form (e.g., written) is more reliable than oral evidence.
  • Original documents are more reliable than copies.
  • Evidence from a client's system is more reliable if the related internal controls are effective.
Test your understanding 2

Question: List and explain FOUR methods of selecting a sample of items to test from a population in accordance with ISA 530 Audit Sampling.

Solution:

  • Random selection: Ensures each item has an equal chance of being selected, for example, by using random number tables.
  • Systematic selection: A sampling interval is determined (e.g., every 50th item) after a random starting point is chosen.
  • Haphazard selection: The auditor selects a sample without a structured technique, consciously avoiding bias.
  • Block selection: The auditor selects a block of contiguous items from the population. This is generally the least representative method.
  • Monetary unit sampling: Ensures that each monetary unit (e.g., each $1) in a population has an equal chance of being selected.
Test your understanding 3

Question: List and explain FOUR factors that will influence the auditor's judgment regarding the sufficiency of the evidence obtained.

Solution:

  • **Risk of material misstatement:** As risk increases, more evidence is required.
  • **Materiality:** More evidence is gathered for material items.
  • **Nature of internal controls:** The auditor needs less evidence if internal controls are strong.
  • **Auditor's knowledge:** Less evidence is needed if the auditor has good knowledge of the business and trusts management integrity.
  • **Sample size:** A larger sample size provides more evidence.
  • **Reliability of evidence:** Less evidence is needed if the evidence is reliable.
Test your understanding 4

Solution:

Question 1: In respect of the tests of controls over revenue, which TWO of the following are appropriate responses?

  • (i) Pick alternative items to test in place of those just tested and ignore the deviations.
  • (ii) Extend the sample size.
  • (iii) Perform increased substantive testing.
  • (iv) Extrapolate the deviation across the population.
  • A. (i) and (ii)
  • B. (ii) and (iii)
  • C. (i) and (iv)
  • D. (iii) and (iv)

Answer: B. The auditor should not ignore deviations. A high deviation rate means controls are not effective, so the auditor should increase substantive testing. Deviations are not extrapolated; the rate is simply compared to the tolerable deviation rate.

Question 2: In respect of the substantive testing performed over purchases, what action should the auditor now take?

  • A. Inform the client of the misstatement and ask them to correct it
  • B. Calculate the materiality of the misstatement in relation to the financial statements
  • C. Extend the sample
  • D. Compare the misstatement with the tolerable deviation rate

Answer: C. The total projected misstatement is $3,406, which exceeds the tolerable misstatement of $3,000. Therefore, the auditor must perform further audit procedures by extending the sample.

Question 3: Select the sampling method used in each of the procedures stated.

  • Test of controls over revenue: The sample was chosen by selecting every 37th invoice. This is **systematic sampling**.
  • Substantive procedure over purchases: The sample was chosen by selecting 50 invoices from anywhere in the purchase day book, avoiding bias. This is **haphazard sampling**.

Question 4: Which of the following statements is TRUE?

  • A. Sampling refers to where less than 100% of the items in a population are tested and have an equal chance of selection
  • B. Deviations must be extrapolated to determine the effect on the population
  • C. Block sampling is where the auditor tests all items in a population
  • D. Monetary unit sampling is a statistical method of sampling

Answer: D. Monetary unit sampling is a statistical method. Option A is incorrect as not all sampling methods (e.g., haphazard) give an equal chance of selection. Option B is incorrect as deviations are not extrapolated; misstatements are. Option C is incorrect as block sampling tests a block of contiguous items, not all items.

Test your understanding 5

You are planning the audit of Worsley Co. The company sells diamonds and other precious stones. You have decided to use the work of an auditor's expert to provide sufficient appropriate evidence over the valuation of inventory.

Question 1: Before appointing an auditor's expert, what factors must the auditor consider?

  • A. (i), (ii) and (iii)
  • B. (ii), (iii) and (iv)
  • C. (i), (iii) and (iv)
  • D. (i), (ii), (iii) and (iv)

Answer: A. The auditor must consider competence, capability, and objectivity. Reliability of source data is part of the evaluation of the expert's work, not a factor in their appointment.

Question 2: How can the auditor assess the competence of an auditor's expert?

  • A. (i) and (ii) only
  • B. (ii) and (iii) only
  • C. (i) and (iii) only
  • D. (i), (ii) and (iii)

Answer: C. The auditor can obtain professional certificates and inspect the register of professional bodies. Asking for a confirmation of independence relates to objectivity, not competence.

Question 3: What must be agreed with the auditor's expert in writing before the work is performed?

  • A. (i), (ii), (iii) and (iv)
  • B. (i), (iii) and (iv) only
  • C. (iii) and (ii) only
  • D. (i), (ii) and (iv) only

Answer: B. The responsibilities of each party, the deadline for the work, and the scope and objectives must be agreed. Inherent limitations are not communicated to the expert but are included in the engagement letter to the client.

Question 4: Which of the following statements is true in respect of the expert's work?

  • A. The auditor can rely on the expert's work and does not need to review it
  • B. The auditor may choose not to review the expert's work if it is an area in which the auditor has knowledge or experience
  • C. The auditor must review the assumptions and source data used by the expert to ensure they were reasonable and reliable
  • D. The auditor will engage a second expert to review the work of the first to ensure sufficient appropriate evidence has been obtained

Answer: C. The auditor must review the expert's work, including their assumptions and source data, to determine if it is appropriate for audit purposes. The auditor cannot simply rely on the expert's work without independent review.

Question 5: Which of the following statements best describes a management's expert?

  • A. A management's expert is an employee of the company
  • B. A management's expert is someone appointed by the company to provide evidence for the auditor
  • C. A management's expert is someone recommended by the auditor which management appoints to provide evidence for the audit
  • D. A management's expert is someone appointed by the company to provide evidence for management which may be relied upon by the auditor

Answer: D. A management's expert is appointed by management to produce evidence for their own use, and the auditor may choose to rely on that work if it is relevant and reliable.