CHAPTER Audit Evidence and Documentation AN AUDIT

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Audit Evidence and Documentation                                                          AN AUDIT: SUMMARY
                                                                                 Plan the engagement: Identify risks and areas

                                                                                 where internal controls may be relied upon
                                 CHAPTER                                            "NET": Nature, extent and timing of audit
                                                                                    procedures is planned.
                                                                                 Where internal controls may be relied upon,
                                                                                 test those controls to justify reliance
                                                                                 Apply substantive procedures for everything
                                                                                 else.               ROUTINE
                                                                                                NON-ROUTINE TRANSACTIONS

      Bob Anderson, UCSB                                Intro CHAPTER
                                                              & Chapter 5-1         Bob Anderson, UCSB                          Intro & Chapter 5-2

    MANAGEMENT'S ASSERTIONS                                                         PCAOB ONE-UP'S THE AICPA
                                                                              I WILL teach using AICPA management assertions, but know
"Coverd" (i.e covered but misspelled):                                           that it can be broken into more confusing detail, which the
                 Most difficult to test
Completeness                                                                     PCAOB did which is not "CEO APROVeD"
                               High Risk due to subjectivity, therefore       Completeness
CutOff                                  generally focus in audit
Valuation, allocation & accuracy                                              Occurrence
Existence & occurrence                                                        Allocation
Rights & Obligations
Presentation and Disclosure                                                   Obligations

                                                        Intro & Chapter 5-3                                                     Intro & Chapter 5-4

THIRD STANDARD OF FIELDWORK                                                                        Competence of Evidential
So management makes the COVERD assertions.
  It is then the auditors responsibility to validate                                      To be appropriate evidence must be:
  those assertions, as required by the third                                                   Relevant- does it apply to the objective we are
  standard:                                                                                    testing?
                                                                                               Reliable/ Valid- Is the evidence any good?
"Sufficient Appropriate Audit Evidence" is to be                                                 Independent sources have greater reliability
   obtained to afford a reasonable basis for an                                                   than those within the client organization.
   opinion regarding the financial statements                                                    Strong internal control increases reliability of

   under audit"                                                                                   evidence created within the client organization.
                                                                                                 Directly obtained evidence is more reliable than
                                                                                                  evidence obtained second hand.
                                   RELEVANT &
                                  see next slide

        Bob Anderson, UCSB                                         Intro & Chapter 5-5          Bob Anderson, UCSB                          Intro & Chapter 5-6

       SUBSTANTIVE PROCEDURES                                                              SUBSTANTIVE Audit Procedures
Recall that we generally utilize a "balance sheet" approach- we are testing sales by
   testing accounts receivable.
                                                                                               Accounting information system
Can be:                                                                                        Documentary evidence
   Transactional                                                                                   Tracing
        OR                                                                                         Vouching
   Ending balance
By testing the ending balance, then you are inherently testing ALL of the transactions.            Reconciliations
   If you wanted to audit the ending cash balance, do you think we would need to
   look at every single entry that impacted cash during the year?
                                                                                               Third-party representations--Confirmation
                                                                                               Physical examination
BALANCE SHEET APPROACH- MORE:                                                                  Computations--Reperformance
Does NOT imply ignoring the income statement! At a MINIMUM you must perform
   analytics of the income statement.                                                          Data interrelationships--Analytical procedures
   In many instances, can perform easy substantive procedures on the income
   statement lines, or in connection with testing a balance sheet account.
                                                                                               Client representations       WEAKEST

                                                                                                   Letters of representations

        Bob Anderson, UCSB                                         Intro & Chapter 5-7          Bob Anderson, UCSB                          Intro & Chapter 5-8

                   Vouching vs. Tracing                                                                     INTERNAL CONTROLS
                                                                                              MUST obtain an understanding of the internal controls (that's the 2nd standard
 When we examine audit evidence we often look                                                   of fieldowkr... the "I" in PIE from Chapter 2)
  for one thing to match another. We could be
                                                                                              Many "classes of transactions" are very "routine" to a client. Accordingly the
  vouching or tracing... we "vouch" FROM the                                                    client may establish strong internal controls over those transactions to
  financials and we "trace" TO them:                                                            ensure that misstatements are Prevented or Detected in a timely fashion.
                                                                                                If the internal controls over a class of transactions is strong the auditor
                                                                                                MAY rely upon those controls. However, in order to rely, the auditor must
                                                                                               Tests of Design (TOD's): Would the controls prevent/ detect errors?
 When testing existence (of something recorded                                                 Tests of Operational Effectiveness (TOE's): Are the controls functioning as
  in the financial statements) we ...                                                           designed?

                                         VOUCH                                                IF NOT PERFORMING TOD'S AND TOE'S TO RELY UPON INTERNAL
                                                                                                 CONTROLS, THEN THE AUDITOR MUST PERFORM "SUBSTANTIVE TESTS".
 When testing completeness (to see if something                                                  WHY WOULD AN AUDITOR GENERALLY SEEK TO RELY UPON CONTROLS
                                                                                                 FOR ROUTINE TRANSACTIONS?
  is recorded in the financial statements) we ...
                                          TRACE                                                                       EFFICIENCY IN THE AUDIT!!

                                                                       Intro & Chapter 5-9           Bob Anderson, UCSB                                 Intro & Chapter 5-10

                                      Audit Risk                                                                Audit Risk Formula
An audit can NOT provide absolute assurance. The risk that there is a material
error in the financial statements undetected by the audit is the DETECTION
RISK. All of the risks combined are the "audit risk"

There are several risk factors which can be categorized into three groups:
1. Inherent Risk--Risk of a material misstatement occurring in an            SPECIFIC
   assertion assuming no related internal controls. Impacted by
                                                                              TO THE
                                                                                                                   AR = IR * CR * DR
   factors such as:                                                                                                                 RMM
       Complexity of transactions and/ or accounting issues;
       Number of transactions;                                                CLIENT
       Degree of judgment involved                                                                        AR   =   Audit risk
                                                                             AND ITS
       Volatility of valuations                                                                           IR   =   Inherent risk
2. Control Risk--Risk that a material misstatement in an assertion                                        CR   =   Control risk
   will not be prevented or detected on a timely basis by the             OPERATIONS-
   company's internal control.                                            combined= Risk of               DR   =   Detection risk
     Controls are designed and implemented by management to mitigate          Material
     the inherent risks                                                     Misstatement
     Controls can be designed to PREVENT and/ or DETECT an error               (RMM)
     Control risk is the residual risk that an error was neither
3. Detection Risk--Risk that the auditors' procedures will lead them
   to conclude that a material misstatement does not exist in an          SPECIFIC TO
   assertion when in fact such misstatement does exist.                  THE AUDITORS
          Bob Anderson, UCSB                                        Intro & Chapter 5-11             Bob Anderson, UCSB                                 Intro & Chapter 5-12

            An Illustration of Audit Risk                                              Basic Approaches to Auditing Accounting
                                                    BEFORE application of                            Estimates
                                     Sand           internal controls,
                                                    potential for
                                                    misstatements is

                                                                                            Review and test management's process
                          Inherent Risk
                                                    Internal controls                       for developing the estimate.
                                                    prevent/ detect & rectify
         Risk of                                    misstatements,                          Independently develop an estimate to
                                                                                            compare to management's estimate.
        Material                                    mitigating inherent risk
                          Control Risk
                                                                                            Review subsequent events or
                                                                                            transactions bearing on the estimate.
                                                    Audit procedures
                                                    DETECT misstatements
                                                    not prevented by client
                                                    controls                                        VALUABLE TOOL IN AUDITORS' ARSENAL:
                         Detection Risk
                                Risk That
      Audit Risk   =      Auditors Fail to Detect
                          Material Misstatement
    Bob Anderson, UCSB                                         Intro & Chapter 5-13         Bob Anderson, UCSB                    Intro & Chapter 5-14

                                                                                                    USE OF SPECIALISTS
            Auditing Fair Values                                                      The auditor is responsible for the adequacy of the
                                                                                        procedures applied. Maybe they need a specialist to
                                                                                        supplement where they lack specific expertise. If
   If the item is traded on an organized                                                they do, they are responsible for the work of the
   market, fair value may be obtained from                                              specialist, and at a minimum must (DON'T FORGET
                                                                                        TO DOCUMENT)
   market prices                                                                       Satisfy themselves with the professional qualifications
   If the item does not trade on an organized                                           of the specialist
   market determine fair value by:                                                     Obtain an understanding of the methods and

      Analyzing to a similar market is possible                                         assumptions used by the specialist
                                                                                       Test any data furnished to the specialist (client could
      Using a valuation model                                                           give them bad data- a specialist just works with what
      Use of specialists                                                                they get, they do not "audit" it)
      Using subsequent information

    Bob Anderson, UCSB                                         Intro & Chapter 5-15         Bob Anderson, UCSB                    Intro & Chapter 5-16

          Sufficiency of Audit Documentation                                    Functions of Working Papers
   Audit documentation should be sufficient to                             Provide a means of assigning and
   enable members of the audit team AND                                    coordinating audit work
   future reviewers of the workpapers to:                                  Aid in supervising and reviewing the audit
      To understand who performed and reviewed                             work
      the work                                                             Provide support for the auditors' opinion
      To understand what work was performed                                Document the auditors' compliance with
      To show that the accounting agree or reconcile                       generally accepted auditing standards,
      to the financial statements                                          especially the standards of field work
                                                                           Aid in planning and conducting future audits

    Bob Anderson, UCSB                       Intro & Chapter 5-17       Bob Anderson, UCSB                            Intro & Chapter 5-18

          Types of Working Files                                            TYPES OF WORKPAPERS
Current files- AKA Workpapers Specific to the
  period being audited (see next slide)
Permanent files- Documents which have an                                                          AUDIT                    PERM-FILE
  impact to current/ Prior/ Future periods,                         GENERAL BINDER=

  examples:                                                                                  Working trial balance    Per prior slide,
       Debt agreement                                               Planning
                                                                                             Lead schedules           legal and other
                                                                                             Adjusting journal        documents of
       Articles of incorporation                                                             entries and reclass.
                                                                    General                                           recurring nature
       Important resolutions of the BOD     RETENTION REQUIRED:     compliance items         entries
                                                                                             Supporting schedules
       Stock subscription agreements         7 YEARS B Y PCAOB      Completion              Analysis of a ledger
       Deferred compensation plans                                  Formal evidence of      Reconciliations
                                              5 YEARS BY AICPA
       Employment contracts (if material)                           required                 Computational
                                                                    considerations and       working papers
                                                                    reviews                  Corroborating

    Bob Anderson, UCSB                       Intro & Chapter 5-19       Bob Anderson, UCSB                            Intro & Chapter 5-20

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