CHAPTER 7

Audit and review evidence

EXAM FOCUS
Evidence gathering is a highly examinable topic and can cover both the balance sheet and the
income statement. Questions on evidence are a gift to the well-prepared student because they
enable the production of a well-structured answer with high scoring marks. The good student
focuses on detail and avoids vague and woolly answers. In this chapter we look at ISA 500
which sets out the fundamental principles of evidence gathering.

There are a number of auditing standards that address general issues in evidence gathering.
They are as follows:

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services to third party organisations.

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specialist skills such as lawyers, surveyors or specialist consultants.

SYLLABUS AND STUDY GUIDE COVERAGE

This chapter covers the following elements of the ACCA study guide:

9 The Work of Others

Describe the:

¨ extent to which external auditors are able to rely on the w ork of:

- internal audit
- experts
- service organisations

and recognise where reliance is needed.

¨ extent to which internal auditors are able to rely on the w ork of:

- experts
- service organisations.

¨ conditions that must be met before reliance can be placed on the w ork of others
and the planning considerations in co-ordinating the work of others.

¨ division of responsibilities between auditors and others.

¨ extent to which reference to the work of others can be made in audit and review
reports.

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16 Other Audit and Review Evidence I

¨ Describe the sources and relative merits of the different types of evidence
available.

¨ Describe the financial statem ent assertions com monly reported on and the
principles and objectives of balance and transaction testing.

¨ Explain the problem s associated with the audit and review of accounting
estimates.

¨ Describe the types of evidence available in smaller entities.

¨ Evaluate the quality of evidence collected.

In order to cover these elements the follow ing topics are included:

ISA 402 Service organisations

ISA 500 Audit evidence
ISA 540 Audit of accounting estimates
ISA 620 Using the w ork of an expert

1 Obtaining audit evidence

1.1 Introduction
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Audit evidence consists of any information used by the auditor in arriving at the conclusions
necessary for his opinion on the financial statements. He has to exercise his skill and judgement
in deciding how m uch evidence he needs and from w hat sources he can obtain it.

1.2 Sufficiency and appropriateness

Sufficiency is a measure of the quantity of audit evidence required; appropriateness is a
measure of the relevance and reliability of the evidence.

Sufficiency

Although evidence may be good as far as it goes, it may not be enough on its own. For
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sufficient evidence that the balance sheet figure for accounts payable will necessarily show a
true and fair view.

Auditors seek to provide reasonable, not absolute, assurance that the financial statements are
free from material misstatement. In form ing their audit opinion, therefore, auditors do not
normally examine all of the information available. Appropriate conclusions can be reached
about a financial statement assertion using a variety of means of obtaining evidence, including
sampling.

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such factors as:

¨ the assessment of the nature and degree of risk of m isstatement at both the financial
statement level and the account balance or class of transactions level;

¨ the nature of the accounting and internal control system s, including the control
environment;

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 Chapter 7 Audit and review evidence

¨ the materiality of the item being examined;

¨ WKHH[SHULHQFHJDLQHGGXULQJSUHYLRXVDXGLWVDQGWKHDXGLWRUV·NQRZOHGJHRIWKHEXVLQHVV
and industry;

¨ the findings from audit procedures, and from any audit work carried out in the course of
preparing the financial statements, including indications of fraud or error; and

¨ the source and reliability of information available.

Relevance

The relevance of the audit evidence should be considered in relation to the overall audit
objective of forming an opinion and reporting on the financial statements. To achieve this
objective the auditor needs to obtain evidence to enable him to draw reasonable conclusions in
answer to the follow ing questions.

Balance sheet items

Have all the assets and liabilities been recorded?

Do the recorded assets and liabilities exist?

Are the assets owned by the enterprise and are the liabilities properly those of the enterprise?

Have the amounts attributed to the assets and liabilities been arrived at in accordance with the
stated accounting policies, on an acceptable and consistent basis?

Have the assets, liabilities, capital and reserves been properly disclosed?

Income statement items

Have all income and expenses been recorded?

Did the recorded income and expense transactions in fact occur?

Have the income and expenses been measured in accordance with the stated accounting
policies, on an acceptable and consistent basis?

Have income and expenses been properly disclosed w here appropriate?

Reliability

Although the reliability of audit evidence is dependent upon the particular circum stances, the
following general presumptions may be found helpful.

¨ W ritten evidence is m ore reliable than oral evidence.

¨ Evidence obtained from independent sources external to the enterprise is m ore reliable
than that secured solely from within the enterprise ie, internally generated.

¨ Evidence generated internally is m ore reliable when the related accounting and internal
control system s are effective.

¨ Evidence originated by the auditor by such means as analysis and physical inspection is
more reliable than the evidence obtained from others ie, client generated evidence.

The auditor should consider w hether the conclusions drawn from differing types of evidence
are consistent w ith one another. W hen audit evidence obtained from one source appears
inconsistent with that obtained from another, the reliability of each remains in doubt until
further work has been done to resolve the inconsistency. However, when the individual item s
of evidence relating to a particular matter are all consistent, then the auditor may obtain a
cumulative degree of assurance higher than that w hich he obtains from the individual item s.

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1.3 Methods of obtaining audit evidence

ISA 500 gives some help on the methods of obtaining audit evidence and identifies the
following possibilities.

¨ Inspection eg, physical inspection of assets.

¨ Observation eg, observation of procedures such as attendance at the inventory count.

¨ Enquiry and Confirmation eg, information obtained orally or in writing from persons inside
or outside the enterprise.

¨ Computation eg, checking the arithmetical accuracy of accounting records.

¨ Analytical Procedures eg, ratio analysis on financial statements.

Examples of these methods in specific areas will be given both in the follow ing chapters and in
the solutions to practice questions.

1.4 Direct versus indirect audit evidence

The results of both compliance tests (transaction testing) and substantive tests (balance testing)
will supply the audit evidence that the auditor needs in order to form his opinion. It is
necessary to emphasise the difference between the two types of test and therefore the two
types of evidence they provide.

Satisfactory com pliance tests indicate that there are controls in operation which ensure that
transactions should be processed correctly. This is indirect audit evidence.

Substantive tests are tests w hich ensure that transactions have been processed correctly. This is
direct audit evidence.

This distinction is particularly important as the auditor cannot rely solely on indirect evidence
in arriving at his opinion.

1.5 Financial statement assertions

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the sufficiency and appropriateness of audit evidence from such procedures together with
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The examiner can place great emphasis on the relationship between accounting and auditing
and may ask you to explain the financial statement assertions that underlie the process of
evidence gathering. Financial statement assertions are the representations made by the
directors in relation to an account item or a class of transactions that are embodied in the
financial statements. W hen the directors sign the financial statements they are telling the users
or readers that:

¨ existence: an asset or a liability exists.

¨ rights and obligations: an asset or a liability pertains to the entity.

¨ occurrence: a transaction took place pertaining to the entity.

¨ completeness: there are no unrecorded assets, liabilities, transactions or events.

¨ valuation: an asset or liability is recorded at an appropriate carrying value.

¨ measurement: a transaction is recorded at the proper am ount and the revenue or expense
is allocated to the proper period.

¨ presentation and disclosure: disclosure and classification are in accordance with the
applicable reporting framework (eg IASs).

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 Chapter 7 Audit and review evidence

<RX PD\ ILQG ´&29(5 0 3µ D XVHIXO P QHP RQLF WR UHPHPEHU WKH VHYHQ ILQDQFLDO VWDWHPHQW
assertions described above.

1.6 The audit of smaller entities

The auditor is likely to find less sophisticated internal control system s in smaller entities, so he
will have to carry out more substantive testing and less compliance testing than in an audit of a
larger entity. H owever audit evidence should still be able to be gathered to support all the
financial statement assertions above, even in an audit of a smaller entity.

The IAASB has issued an International Auditing Practice Statement IAPS 1005 The special
considerations in the audit of small entities to provide guidance to auditors in carrying out the
audit of small businesses in accordance with ISAs. In a climate of public debate about the
appropriateness of mandatory small audit, the IAASB concludes that it is perfectly possible to
carry out an effective and useful audit of any business, however small.

2 The audit of accounting estimates (ISA 540)

2.1 Introduction
Financial statements contain a number of items that are subject to the judgement of the
directors and cannot be measured precisely. Inventories, receivables and depreciation are
three sim ple examples of items that involve skill and judgement. ISA 540 sets out the rules of
good practice in this area.

´The auditor should obtain sufficient appropriate audit evidence regarding accounting
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precise means of measurement. Examples are:

¨ allowances to reduce inventory and accounts receivable to their estimated realisable value;
¨ depreciation charges;
¨ accrued revenue;
¨ deferred tax;
¨ provision for a loss from a lawsuit;
¨ profits or losses on construction contracts in progress; and
¨ provision to meet warranty claims.

Directors and management are responsible for making accounting estimates included in
financial statements. These estimates are often made in conditions of uncertainty regarding the
outcome of events that have occurred or are likely to occur and involve the use of judgement.
As a result, audit evidence obtained is generally less conclusive when accounting estimates are
involved. Consequently, in assessing the sufficiency and appropriateness of audit evidence on
which to base the audit opinion, auditors are more likely to need to exercise judgem ent in their
consideration of accounting estimates than in other areas of the audit.

2.2 Audit procedures

ISA 540 recognises the difficulty in auditing accounting estimates and suggests the auditors
should obtain evidence so that they are assured that the am ount is reasonable and properly
disclosed in accordance with law and GAAP.

The guidance on audit procedures is sum marised below :

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an accounting estimate:

(a) review and test the process used by management to develop the estimate;

(b) use an independent estimate for comparison with that prepared by management; or

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(c) UHYLHZVXEVHTXHQWHYHQWVZKLFKFRQILUPWKHHVWLPDWHPDGHµ

Review and testing the process used by management

The steps normally involved in the review and testing of the process used by management are:

(a) evaluation of the data and consideration of the assumptions on which the estimate is
based;

(b) testing of the calculations involved in the estimate;

(c) comparison, w hen possible, of estimates made for prior periods with actual results of
those periods; and

(d) consideUDWLRQRIPDQDJHPHQW·VUHYLHZDQGDSSURYDOSURFHGXUHV

Use of an independent estimate

Auditors may make or obtain an independent estimate and compare it with the accounting
estimate prepared by management. W hen using an independent estimate auditors w ould
generally evaluate the data, consider the assumptions and test the calculation procedures used
in its development. It may also be appropriate to compare independent estimates m ade for
prior periods with actual results of those periods.

Review of subsequent events

Transactions and events which occur after period end may provide audit evidence regarding
DQ DFFRXQWLQJ HVWLPDWH PDGH E\ PDQDJHPHQW  7KH DXGLWRUV· UHYLHZ RI VXFK WUDQVDFWLRQV DQG
events may reduce, or even remove, the need for them to review and test the process used to
develop the accounting estimate or to use an independent estimate in assessing the
reasonableness of the accounting estimate.

2.3 Evaluation of the results of audit procedures

The auditor m ust assess the following:

¨ the reasonableness of the estimate.

¨ consistency with other evidence.
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¨ the impact of any differences individually and cumulatively.

If the estimates are reasonable on a cum ulative basis no action need be taken. Otherwise
management m ust be requested to revise the estimate.

Ultimately if the estimates are not reasonable the auditor m ust consider the impact on his audit
report.

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3.1 Introduction
M any businesses employ specialist organisations to carry out special tasks. Examples of these
tasks are:

¨ Payroll processing by a computer bureau.

¨ Accounting services provided by a third party organisation.
¨ Share registration services for companies that have their shares listed on a Stock Exchange.

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 Chapter 7 Audit and review evidence

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the basis of a contract for a period of years. For example, an outsourcing decision that affects
practically every adult in the UK was the decision taken by the UK tax authorities to outsource
their IT system s for personal taxation to the A merican corporation EDS. This contract expires
in the year 2004 but there are signs that the relationship w ill continue.

M any advantages are cited to justify outsourcing decisions:

¨ Quality provision. A custom er-provider relationship drives the provider to deliver quality
in the interest of maintaining commercial goodwill.
¨ M arket value for services. The user pays a fair market price and therefore expects value for
money.
¨ Overcom ing a skill shortage. Outsourcing provides essential skills that may be in short
supply without the problem s of recruitment and long-term employment obligations.
¨ No waste. The customer pays only for the time or resources used.
¨ Risk transfer. The contractor takes over service provision and in some cases also takes on
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3.2 The case against outsourcing

¨ No guarantee of quality. It is difficult to evaluate a service in advance of receiving it. As

the provision of services is totally variable the customer is powerless to prevent quality
lapses.
¨ The captive customer syndrome. If a customer is locked into an agreement that lasts for
several years it may be difficult to change to another contractor because all systems are
geared to a particular method of operation.

3.3 Contractual terms

A service level agreement (SLA) is the basis of most outsourcing deals and defines the
performance variables and the tariff charges w hich are often based on the volume of
transactions. The SLA also provides for a system of penalties that can be levied by the
contractee on the contractor for breaches of the service agreement.

3.4 Outsourcing the finance department

This idea might seem like dangerous heresy but in theory no service provider can claim an
imm unity to being outsourced. Computer technology is now able to process any data
anyw here without the user being aware of geographical, technical or organisational
boundaries. The finance function like any service provider must deliver value for money and
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why it would be undesirable to outsource it.

3.5 The case for an in-house finance department

M easurement of outputs

Routine transaction processing can be measured in terms of inputs, processes and outputs
because the work content is relatively structured and standardised. However many finance
functions are not mechanical and are highly cerebral. They demand the application of
considerable skill and experience that is only developed by a core of dedicated (in every sense)
staff members w ho have become thoroughly familiar with the business system. It w ould
therefore be unwise to lose this pool of human knowledge if the finance function was
outsourced to a specialist provider such as an international firm of accountants or an
international consultancy.

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Ethics, confidentiality and Chinese walls

The finance function is generally regulated by a strong ethical framework that is both corporate
and also highly personal. The finance function is staffed by competent persons of good
standing w ho subscribe to the usual standards of confidentiality in relation to the affairs of
their employer. If they are members of a professional body they have a duty of confidentiality
as a condition of membership. If the function is outsourced this level of team spirit and loyalty
may not be achieved. This need to preserve confidentiality is critical in relation to information
which may be market sensitive and not in the public domain.

Continuity and quality of service

The finance function occupies a special place in the business hierarchy as the provider of
sensitive information on corporate performance. This highly personal approach to information
provision could not be replicated by a third party service organisation.

3.6 The case for contracting out the finance function

M any finance functions are over-manned and inefficient because of empire building by senior
staff or because of poor practices and methodology which are hallowed through tradition.

M any finance staff are limited in terms of skills and experience and may seriously
underperform in their roles.

M any third party organisations have access to skills that are not readily available to an in-
house finance department. Their performance is therefore likely to be m ore efficient and
effective.

Salary and overhead costs can be reduced in both the short and long term if routine functions
are contracted out to a third party provider w ho can exploit economies of scale.

Finally while there are recorded instances of operational tasks being contracted out
successfully there is no evidence to suggest that there is an effective substitute for the Chief
Financial Officer who must remain in-house to have any impact at all.

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W hat this means in simple terms is that the auditor cannot avoid any audit responsibility
because a third party organisation is employed to process accounting records or any other
PDQDJHPHQWIXQFWLRQ,IWKHVHUYLFHRUJDQLVDWLRQ·VDFWLYLWLHVDUHrelevant to the audit then the
auditor must:

¨ Familiarise himself with the terms of reference and method of operation of the
organisation.

¨ Understand the systems used to m onitor activities.

¨ Satisfy him self that the organisation allows his client to discharge all fiduciary and legal
obligations.

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Risk factors to be considered:

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preservation of confidentiality and the compliance with laws and regulations.

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 Chapter 7 Audit and review evidence

¨ The degree of power exercised by the organisation to initiate and process transactions.
Routine processing of accounting transactions which are originated by the audit client are
relatively low risk areas.

¨ The checks and balances operated by the service organisation.

¨ The integrity and reputation of its management and staff.

¨ The financial stability of the organisation itself is a significant risk factor.

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Risk factors to be considered:

¨ The internal controls operated by the organisation to provide accurate output to clients.

¨ The system of identifying shortfalls in performance.

¨ The track record of errors and omissions.

¨ The systems of rectifying errors and compensation for client complaint. This is usually
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The auditor should obtain information necessary for the purposes of his audit and the
considerations here are no different from any other audit.

¨ Inspection of records.

¨ Assessing controls.

¨ Obtaining representations on transactions and balances and any assets or documents held
as custodian.

¨ Performing analytical review on records or returns made by the organisation.

¨ Visiting the organisation to discuss critical issues with management.

¨ Obtaining confirmations from the auditors of the service organisation.

¨ Requesting the internal or external auditors to perform necessary audit procedures.

¨ Inspection of progress reports on the adherence to the SLA as part of a normal dialogue
between contractor and contractee.

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There are three areas where audit reporting may be com promised by deficiencies in service
provided by the organisation:

¨ Inadequate books or records of account.

¨ Inability to carry out appropriate tests on the records kept by the service organisation.

¨ Inability to obtain a report from the external auditors of the service organisation as to the
adequacy of its systems of internal control.

In such circum stances there is a lim itation of scope and the auditors may need to:

¨ Describe the factors that have contributed to the lack of evidence.

¨ Qualify their opinion or issue a disclaimer of opinion if the breach is of a fundamental

nature.

4 Using the work of an expert (ISA 620)

4.1 Introduction
Auditors frequently rely on evidence generated by third parties with special training or skills,
for example a business may employ a chartered surveyor to carry out a revaluation of freehold
properties. An auditor is well trained in various disciplines but cannot be expected to be an
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124
 Chapter 7 Audit and review evidence

with special skills in a particular field other than accounting and auditing. Experts may be
engaged by the client or by the auditor.

4.2 When is an expert opinion needed?

This is set out in ISA 620.

During the audit the auditors may obtain, in conjunction w ith the entity or independently,
audit evidence in the form of reports, opinions, valuations or statements of an expert.
Examples are:

¨ valuations of certain types of assets, for example land and buildings, plant and machinery,
works of art, precious stones, unquoted investments and intangible assets;

¨ determination of quantities or physical condition of assets, for example minerals stored in

stockpiles, underground mineral and petroleum reserves and the remaining useful life of
plant and machinery;

¨ determination of amounts using specialised techniques or methods, for example pensions

accounting and actuarial valuations;

¨ the measurement of work completed and to be completed on contracts in progress; and

¨ legal opinions concerning interpretations of agreements, statutes and regulations, or on the

outcome of litigation or disputes.

W hen determining whether to use the w ork of an expert, the auditors must review:

(a) the importance of the matter being considered in the context of the financial statements
(its materiality);

(b) the risk of misstatement based on the nature and complexity of the matter being
considered; and

(c) the quantity and quality of other available audit evidence.

If the auditors determ ine that it is appropriate to seek to use the work of an expert, the
approach is discussed and may be agreed with management or the directors. If management
or the directors are unable or unwilling to engage an expert, the auditors may consider
engaging an expert or w hether sufficient appropriate audit evidence can be obtained from
other sources. If unable to obtain sufficient appropriate audit evidence, they consider the
implications for their report.

4.3 Competence and objectivity of the expert

Typical issues here are:

¨ Professional qualification or certification.

¨ Experience and reputation.
¨ Financial dependence on the client.

The risk of bias could arise if the expert is employed by the entity or has some financial
relationship with it.

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Audit evidence may be obtained through a review of the terms of reference, which are often set
out in written instructions from the entity to the expert. Such instructions to the expert may
cover such matters as:

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¨ WKHREMHFWLYHVDQGVFRSHRIWKHH[SHUW·VZ RUN

¨ DJHQHUDORXWOLQHDVWRWKHVSHFLILFPDWWHUVWKHH[SHUW·VUHSRUWLVWRFRYHU

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¨ information regarding the assumptions and methods intended to be used by the expert and
their consistency with those used in prior periods.

In the event that all these matters are not clearly set out in written instructions to the expert,
the auditors may seek to com municate w ith the expert directly to obtain audit evidence in this
regard.

4.5 Assessing the work of the expert

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UHJDUGLQJWKHILQDQFLDOVWDWHPHQWDVVHUWLRQEHLQJFRQVLGHUHGµ

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in the financial statements or supports the financial statement assertions, and consideration of:

¨ the source data used;

¨ the assumptions and methods used;

¨ when the expert carried out the work;

¨ the reasons for any changes in assumptions and methods compared with those used in the
prior period; and

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business and the results of other audit procedures.

W hen considering whether the expert has used source data which is appropriate in the
circumstances, the auditors may consider the following procedures:

(a) making enquiries regarding any procedures undertaken by the expert to establish
whether the source data is sufficient, relevant and reliable; and

(b) reviewing or testing the data used by the expert.

The appropriateness and reasonableness of assumptions and methods used and their
application are the responsibility of the expert. The auditors do not have the same expertise
DQGWKHUHIRUHFDQQRWQHFHVVDULO\FKDOOHQJHWKHH[SHUW·VDVVXPSWLRQVDQGPHWKRGV+RZHYHU
they seek to obtain an understanding of the assum ptions and methods used and to consider
whether they are reasonable, based on their knowledge of the business and the results of other
audit procedures, and compatible with those used for the preparation of the financial
statements.

4.6 Division of responsibility between auditors and others

The external auditor is wholly responsible for his opinion expressed in his audit report. He
cannot pass this responsibility on to any other parties. It is up to the auditor to gather
sufficient appropriate audit evidence before reaching his opinion; the statements of experts and
others are part of the evidence that the auditor must weigh up in his gathering of sufficient
audit evidence.

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 Chapter 7 Audit and review evidence

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land and buildings or to report on the actuarial surplus in the pension scheme fund. The
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4.7 Referring to the work of others in the audit report

Since the auditor is 100% responsible for the audit report, ISA 620 requires that the auditor
should not refer to the w ork of an expert, w hen issuing an unm odified audit report (the usual
situation). Such a reference could be misunderstood to be a qualification of opinion or a
division of responsibility, neither of which is intended.

In some circumstances, when issuing a modified report, it may be appropriate to refer to the
work of an expert in explaining the nature of the m odification. In such circumstances, the
auditor should obtain the permission of the expert before making the reference in his report.

Practice question 1 (The answer is in the final chapter of this book)

Audit trainee

The new audit trainee of your firm of auditors has asked you to advise him on the reliability of
the following types of third party evidence:

(i) valuation of land and buildings by a valuer

(ii) WKHUHSOLHVWRDGHEWRUV·FLUFXODULVDWLRQFRQILUPLQJEDODQFHVGXHWRWKHFRPSDny
(iii) the letter received from the bank confirm ing year-end bank balances.

Required

(a) Discuss the reliability of each of the three types of third party evidence listed in (i) to
(iii) above, and consider the accuracy of the valuations they provide. (9 marks)

(b) For valuations provided by a valuer, describe the w ork you w ould carry out to check
the independence, qualifications and experience of the valuer and the accuracy of the
valuation. (5 marks)

(c) For the letter received from the bank, describe the w ork you w ould perform in
checking the bank reconciliation and that the balance on the bank accounts, as included
in the financial statements, is correct. (6 marks)

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Approach to the question

The fact that the question is quite nicely split into three parts makes the approach slightly
more straightforward. Part (a), discussing the reliability of various form s of audit evidence,
should not just be a regurgitation of the standard. You must obviously state that third party or
externally generated evidence is a reliable source but there will always be credit given to those
who stop and think. In this case the thought process should include a questioning of the
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what value is placed on it by the debtors, and consequently how much time and effort do they
spend on filling it in?

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significance to the information on the bank letter as you do. (M istakes are made on bank
letters.)

You should never be afraid to think and to question. Third party evidence is one of the more
reliable types but it can, and should, still be evaluated and criticised.

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 Chapter 7 Audit and review evidence

5 Summary
The auditor gathers audit evidence and then gives his opinion based on the evidence he has
accumulated. The evidence m ust be sufficient and appropriate before an opinion can be given.

Financial statements necessarily include some accounting estimates where a precise figure
cannot be given. The auditor must decide whether the estimates are reasonable in the
circumstances.

W here an audit client has outsourced key activities to a service organisation, the auditor is still
responsible for giving an opinion on the balances produced by that activity.

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financial statements. Again, the auditor remains responsible for gathering sufficient
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it is likely to be reliable in the circum stances.

129
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130