Audit Evidence And Procedures

 

1.0 INTRODUCTION

Auditing is concerned with the verification of accounting data and with  determining the accuracy and reliability of accounting statements and  reports.

Verification does not mean seeking proof or absolute certainty in  connection with the data and

reports being audited. It means looking for  sufficient evidence to satisfy oneself as auditor that the accounts show a  true and fair view. What is sufficient evidence depends on what  professional experience and knowledge tell one to be satisfactory.

In this note, you shall be considering the different aspects of audit  evidence after making financial statements and assertions as the point of  entry. Also, you shall be exposed to the relevant concepts – audit trail,   Circularization of debtors, audit working papers and auditing procedures  – that will help you in grasping some important elements in auditing.

2.0 OBJECTIVES

At the end of this note, you should be able to:

· verify the various assertions that are made in accounting  statements

· enumerate the varieties of evidence

· describe the basic techniques for collecting evidence

· explain audit trail and  Circularization of debtors

· demonstrate the activities involved in auditing procedures.

3.0 MAIN CONTENT

 3.1 Financial Statements and Assertions

Directors produce or cause financial statements to be produced. In doing  so, they are asserting as follows:

(a) The individual items are:

(i) correctly described;

(ii) show figures which are mathematically correct or fairly  estimated;

(b) The accounts as a whole show a true and fair view.

The idea to grasp is that the producer of a set of accounts is making  assertions about items in the accounts when he puts them in the  accounts.

The assertions he is making are as follows:

(a) Existence: an asset or liability exists at the Balance Sheet date.

This is an obvious assertion with such items as land and  buildings, stocks and others.

(b) Rights and obligations: an asset or liability pertains to the entity  at the Balance Sheet date. This means that the enterprise has, for  example, ownership of an asset. Ownership as an idea is not  simple and there may be all sorts of rights and obligations  connected with a given asset or liability.

(c) Occurrence: a transaction or event took place which pertains to  the enterprise during the relevant period. It may be possible for  false transactions (e.g. sales or purchases) to be recorded. The  assertion is that all recorded transactions actually took place. 

 (d) Completeness: there are no unrecorded assets, liabilities,  transactions or events or undisclosed items. This is important for  all accounts items but is especially important for liabilities.

(e) Valuation: an asset or liability is recorded at an appropriate  carrying value. Appropriate may mean in accordance with  generally accepted accounting principles such as the Companies  Act Rules and Accounting Standards requirements and also  consistent with statements of accounting policies consistently

applied.

(f) Measurement: a transaction or event is recorded at the proper  amount and revenue or expense allocated to the proper period.

(g) Presentation and disclosures: an item is disclosed, classified  and described in accordance with applicable reporting  framework.

As an example, let us look at an item in a balance sheet ‘bank overdraft  N102, 500. 00’. In including this item in the balance sheet, the directors  are making the following assertions.

(a) That there is a liability to the company’s bankers.

(b) That at the balance sheet date, this liability was N102,500.00

(c) That this amount is agreed by the bank.

(d) That the overdraft was repayable on demand. If this were not so,  it would not appear amongst the current liabilities and terms  would be stated;

(e) That the overdraft was not secured. If it were secured, this fact  would need to be stated.

(f) That the company has the authority to borrow from its  memorandum and articles.

(g) That a bank reconciliation statement can be prepared.

(h) That the bank is willing to let the overdraft continue.

If no item ‘bank overdraft’ appeared in the balance sheet, it would  represent an assertion by the directors that no overdraft liability existed  at the balance sheet date.

The assertion will either be corroborated or refuted and any information  that does this is referred to as evidential matter.

3.2 Audit Evidence

The auditor’s attitude to each item in the accounts will be as follows.

(a) Identify the express and implied assertions made by the directors  in including (or excluding) the item in the accounts;

 (b) Evaluate each assertion for relative importance to assess the  quality and quantity of evidence required;

(c) Collect information and evidence;

(d) Assess the evidence for:

(i) appropriateness: appropriateness subsumes the ideas of quality  and reliability of a particular piece of audit evidence and its  relevance to a particular assertion;

(ii) sufficiency.

Note that audit evidence tends to be persuasive rather than absolute and  that auditors tend to seek evidence from different sources or of a  different nature to support the same assertion. Note also that auditors  seek to provide reasonable but not absolute assurance that the financial  statements are free from misstatement. Auditors do not normally  examine all the information available but reach their conclusions about  financial statement assertions using a variety of means including  sampling.

Having formulated judgement on each individual item in (or omitted  from) the accounts, the auditor must formulate a judgement on the truth  and fairness of the accounts as a whole. To do this, he will need other  evidence in addition to the judgements he has made on the individual  items. As an example, he may need evidence of the directors’ implied  assertion that the accounts should be drawn up on the going concern

principle.

3.2.1 Limitations

The quality and quantity of evidence are constrained by the following.

(a) Absolute proof is impossible;

(b) Some assertions are not material;

(c) Time is limited. Accounts must be produced within a time scale  and the auditor may have to cope with less than perfection to  comply with the time scale;

(d) Money is limited. The ideal evidence may be too expensive to  obtain;

(e) Sensitivity. Some items are of greater importance than others  (valuation of property in property companies, for example) or  capable of greater variations (stock and work-in-progress).

3.2.2 Varieties of Evidence

The evidence an auditor collects can be divided into the following

categories:

 (a) Observation:

(i) Examination of physical assets;

(ii) Witnessing the internal control and book-keeping  procedures;

(iii) Observation of the records to ensure that book-keeping and  internal control procedures have been carried out.

(b) Testimony from independent third parties. e.g. bank letters,  debtors circularization.

(c) Authoritative documents prepared outside the firm e.g. title  deeds, share and loan certificates, leases, contracts, franchises,  invoices.

(d) Authoritative documents prepared inside the firm, e.g. minutes,  copy invoices.

(e) Testimony from directors and officers of the company. This may  be formal, for example, the letter of representation, or informal,  for example, in replies to Internal Control Questionnaire (ICQ)  questions.

(f) Satisfactory internal control. For many items, this is the most  useful evidence.

(g) Calculations performed by the auditors. Evidence of the  correctness of many figures can be obtained this way.

(h) Subsequent events. The audit is usually performed well after the  year end and many assertions can be verified by reference to  subsequent events.

(i) Relationship evidence. Evidence confirming the truth about one  item may tend to confirm the truth about another. For example,  evidence confirming the correctness of investment income also  confirms some aspects of the item of ‘investments’.

(j) Agreement with expectations. Verification can be assisted by the  computation and comparison of ratios and absolute magnitudes  with those achieved (a) in the past; (b) by other companies; and

(c) budgeted. Conversely, inconsistencies and unusual or  unexpected items will alert the auditor.

(k) External events. The client is not isolated from the world, and the  auditor should use his knowledge of current events in his  assessment.

3.2.3 Basic Techniques for Collecting Evidence

The basic techniques for collecting evidence are nine in number and  they are as follows:

 (a) Physical examination and count.

(b) Confirmation. This should be in writing, external sources being  preferable to internal sources.

(c) Examination of original documents. Original documents should  be compared with the entries in the books. The usual wording is  vouching.

(d) Re-computation. Additions, calculations, balance extractions, etc.

(e) Retracing book-keeping procedures. Checking postings.

(f) Scanning. This is somewhat indefinite but is widely used,  especially in seeking the unusual or the unlikely.

(g) Inquiry. Asking questions. This is a necessary and valid  technique. However, auditors acquire a habit of always seeking  confirmation of oral answers.

(h) Correlation. Seeking internal consistency in records and accounts.

(i) Observation. Seeing for oneself is the best possible confirmation

especially in connection with internal control systems.

3.2.4 Test Checking

It is not always necessary to obtain evidence about each individual  transaction. The modern approach is to obtain evidence about each type  of transaction by examining a representative sample of each type. This  is called test checking and is applied as much to assets and liabilities as  to routine transactions. The size of the sample to be tested depends on:

(a) the strength of the internal control system;

(b) the materiality of the items;

(c) the number of items involved;

(d) the nature of the item;

(e) the audit risk attached.

3.2.5 Sources of Audit Evidence

Sources of audit evidence include form within (systems, books,  documents, assets, management and staff) and from without (customers,  suppliers, lenders, professional advisers etc.).

The sources and amount of evidence required will depend on,  materiality, relevance, and reliability of the evidence available from a  source, and the cost and time involved.  Relevance of audit evidence depends on whether it assists the auditor in  forming an opinion on some aspects of the financial statements. For  example, evidence that indicates that a recorded asset exists is relevant  to audit objectives.

3.2.6 Reliability of Audit Evidence

The reliability of audit evidence can be assessed to some extent on the  following presumptions.

(a) Documentary evidence is more reliable than oral evidence;

(b) Evidence from outside the enterprise (e.g. bank letter) is more  reliable than that secured solely from within the enterprise;

(c) Evidence originated by the auditor by such means as analysis and  physical inspection is more reliable than evidence obtained from  others (auditors always say ‘show me’ not ‘tell me’).

(d) Evidence for a figure in the accounts is usually obtained from  several sources (e.g. for debtors – a good system with internal  controls, debtors  Circularization, ratio analysis, payment after  date, etc). The cumulative effect of several evidential sources  which give a consistent view is greater than that from a single

source (i.e. 2 + 2 = 5);

(e) Original documents are more reliable than photocopies or  facsimiles.

3.2.7 Sufficiency of Audit Evidence

Sufficiency is a great problem in auditing. The auditor’s judgement will  be influenced as follows.

(a)    His knowledge of the business and its industry;

     (b) The degree of audit risk. Assessment of this is helped by  considering the following points.

(i) Nature and materiality of items of account (e.g. stock is material  and difficult to measure);

(ii) The auditor’s experience of the reliability of the management and  staff and the records;

(iii) The financial position of the enterprise (in a failing enterprise,  directors may wish to bolster profits by over- valuing assets or  suppressing liabilities);

(iv) Possible management bias (as in (iii)), but also the management  may wish to ‘even out’ profits for stock market image or taxation  reasons;

(c) The persuasiveness of the evidence;

(d) The nature of the accounting and internal control systems and the  control environment.

3.2.8 Procedures for Collecting Evidence

The procedures for collecting evidence include:

(a) substantive testing;

(b) analytical review.

These have been considered at some point in this course.

3.3 Consideration of Relevant Concepts

3.3.1 Audit Trail

Audit trail is a trail of evidence linking individual transactions of the  summary totals in the financial statements. The flow of data starts from  recording of source documents such as invoices, cheques, and  summarizing them in the journals at the end of the month and posting to  the ledgers. At the year end, the balances in the ledger are transferred to  the balance sheet and the profit and loss account (final accounts).

3.3.2  Circularization of Debtors

This is one of the auditor’s uses of third parties or external confirmation.   Circularization of debtors is a practice whereby the auditor obtains  permission from the client to contact debtors, requesting them to  confirm the amounts outstanding against them.

Two forms of debtors’  Circularization are as follows:

(i) The negative approach – the debtor is to reply only if he disputes  the balance shown against him;

(ii) The positive approach – the debtor is required to confirm details  of sums of money as outstanding in the records of the clients  company.

3.3.3 Audit Working Papers

According to Parry and Whittington, working papers are the connecting  link between the client’s records and the auditor’s report. The main  object of the audit working papers is to record and demonstrate the steps  which have been followed or adopted by the auditors to enable them  form an opinion on the accounts upon which they are required to report.  Thus, permanent records of evidence gathered during an audit  engagement are established.

They should be prepared in such a manner that if properly indexed, any  auditor can readily locate data relative to any part of the audit. Working  papers are sometimes used as an aid in giving testimonial years after  completion of the audit. Working papers enhance the efficiency with  which the audit is conducted, and should provide the following:

(i) A means of controlling the current year’s audit work and the  basis on which to plan the following year’s work;

(ii) Evidence of work carried out by the auditors;

(iii) Schedules in support of the accounts additional to or summarizing  the details in the client’s work;

(iv) Information about the business which accounts have been audited  including its recent history.

Working papers are divided into two, thus:

· the current file and

· the permanent file.

(a) The Current File

This relates primarily to the set of accounts or statements being audited  and should normally contain the following:

(i) A copy of the accounts or statements on which the auditors are  reporting signed by the directors;

(ii) An internal control questionnaire or other records including flow  charts if appropriately designed to ascertain the adequacy of the  system of internal control;

(iii) An audit programme (details of steps of work performed by  auditors supplemented by particulars and dates of work carried  out and precise details of audit tests performed and their results);

(iv) A schedule for each item in the balance sheet including  comparative figures showing its make-up and how existence,  ownership, valuation and liability have been verified. These  schedules should be cross-referenced to documents arising from  external verifications such as bank tellers, results of   Circularization of debtors, and attendance at physical stocktaking;

 (v) Schedules supporting each item in statutory profit and loss  account including comparative figures and such other items in  trading or subsidiary account as may be necessary; 

(vi) A checklist concerning compliance with statutory disclosure  provision;

(vii) A record showing queries which are raised during the audit and

their disposals. Queries which are not cleared must be entered on  a further schedule for the attention of the senior audit partner.  Material queries which cannot be settled in a satisfactory way  require the qualification of the audit report. All these must be  documented and supported by a note of all discussions with the  client relating to that query;

(viii) A schedule of important statistics or working ratios like:

· gross profit per cent

· current assets to current liabilities

· stock turnover

· trade debtors and trade creditors

· profit to capital employed ratios

The purpose of keeping these ratios is that any significant variation in  any one year may need explanations.

(ix) By extracts from directors’ and shareholders’ minutes of  meetings;

(x) Copies of letters to the client stating any material weaknesses or  matters which the auditors are not satisfied with in respect of  accounting or control procedures;

(xi) Letters of representation, that is, written confirmation by the  client of information and opinions expressed in respect of matters  such as stock values and amount of current and contingent  liabilities.

(b) The Permanent File

This contains matters of continuing importance affecting the company  on the audit. Such matters are as follows:

i. Memorandum and Articles of Association and other appropriate  statutory or legal provisions/regulations;

ii. Copies of other documents and minutes of continuing  importance;

iii. A short description of the type of business carried out and the  place of the business;

iv. List of accounting records and officials responsible for them as  well as the organizational plan;

v. Statements showing a note of accounting matters of importance  such as the history of the results and the bases of accounting  adopted;

vi. The client’s internal accounting and internal audit instructions  plus stocktaking instructions, where applicable.

3.3.4 Auditing Procedures

Let us look at the two major activities involved in the final audit,  namely, vouching and verification.

(a) Vouching

This is the process of examining documentary evidence necessary to  support the recorded transactions which are purported to have taken  place, during the period under review. Such an examination will  establish the following:

i. The correctness of the monetary amounts at which the transaction  is recorded; costs, in the case of purchases; and proceeds, in the  case of sales;

ii. That the transactions were duly authorized in the first place;

iii. That the transactions took place within the period under review;

iv. That the goods and services acquired appeared to be compatible  with the company’s normal trading activities;

v. That the calculation of costs, proceeds, extensions, discounts,  etc., are arithmetically correct;

vi. That the expenditure or income, as the case may be, has been  correctly allocated so that effects have been given to the  distinction between capital, revenue, deferred revenue, etc;

vii. That there is evidence (of rubber stamping and signature or  initials) that the document in question has been authorized and  checked initially as part of the company’s own control  procedures.

(b) Verification

This relates to assets and liabilities and other items in the balance sheet  at the year end. Verification ensures the correctness or otherwise of the  following:

 (i) The stated cost must be related to what is paid for, and evidenced

by a receipt;

(ii) The purchase/acquisition must be duly authorized as evidenced  by a signature, board meetings’ decisions, memorandum and  article of association, etc;

(iii) The assets and liabilities appear in the balance sheet at a fair  valuation;

(iv) The assets exist. Here, the auditor relies on physical verification  wherever practicable and appropriate. This is especially relevant  where the physical assets may be directly compared with the  company’s own records;

(v) The company really owns the assets – ownership. Let us  understand here that existence is one thing, ownership is quite  another. An asset may just be physically present in the  company’s premises to support entries in the books of the  company. Ownership may be verified by reference to a  document of title in relation to that property like a receipt of  purchase. Also, it may be verified by reference to corroborative  evidence or the representation of outside parties.

4.0 CONCLUSION

In this note, you have learnt that the evidence obtained from outside the  organization (from an independent source) provides greater degree of  assurance of reliability for the purpose of an audit. The amount of  evidence that will be sufficient to support auditor’s opinion is a matter  of professional judgement after studying the circumstances around the  organization.

5.0 SUMMARY

In this note, you have learnt the following:

· When accounts are prepared, assertions are made about the items  in the accounts, items omitted and the accounts as a whole;

· The auditor conducts an audit by:

i. identifying the assertions made;

ii. considering the information and evidence he needs;

iii. collecting the evidence and information;

iv. evaluating the evidence;

v. formulating a judgement.

· There are some limitations to the ideal approach to the collection  of evidence;

· There are many different varieties of evidence as well as  techniques for evidence collection;

·  Circularization of debt can be depended upon for its reliability;

· Working papers serve as useful aids to the auditors.

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