ACC 324: LECTURE 5

AUDIT EVIDENCE II
Procedures for Obtaining Audit Evidence
Specifically, the auditor uses one or more of the following types of audit procedures to obtain
audit evidence:
i. Inspection of records or documents;
ii. Physical Inspection of tangible assets;
iii. Observation;
iv. Inquiry;
v. Confirmation;
vi. Recalculation;
vii. Re-performance; and
viii. Analytical Procedures

These audit procedures, or combinations thereof, may be used as risk assessment procedures, test
of controls or substantive procedures, depending on the context in which they are applied by the
auditor. In certain circumstances, audit evidence obtained from previous audits may provide
audit evidence where the auditor performs audit procedures to establish its continuing relevance.

i. Inspection of Records or Documents

Inspection consists of examining records or documents, whether internal or external, in paper
form, electronic form, or other media. Inspection of records and documents provides audit
evidence of varying degrees of reliability, depending on their nature and source, and in the case
of internal records and documents, on the effectiveness of the controls over their production. An
example of inspection used as a test of control is inspection of records or documents for evidence
of authorization.
Some documents represent direct audit evidence of the existence of an asset, for example, a
document constituting a financial instrument such as a stock or bond. Inspection of such
documents may not necessarily provide audit evidence about ownership or value. In additions,
inspecting an executed contract may provide audit evidence relevant to the entity’s application of
accounting policies, such as revenue recognition.
Documentary evidence is least reliable if created and held by the entity (e.g. invoices). It is more
reliable if created by third parties and held by the entity (e.g. a supplier’s Statement). It is most
reliable if it is created by third parties and held by the auditor (e.g. responses to debtor
circularization).
The auditors should consider whether the conclusions drawn from different sources are
consistent with each other. When evidence obtained from different sources are inconsistent with
each other, the reliability of each becomes doubtful and would require further corroboration from
other sources.

ii. Physical Inspection of Tangible Assets

Inspection of tangible assets consists of physical examination of the assets. Inspection of tangible
assets may provide reliable audit evidence with respect to their existence, but not necessarily
about the entity’s rights and obligations or the valuation of the assets. Inspection of individual
inventory items ordinarily accompanies the observation of inventory counting.

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iii. Observation
Observation consists of looking at a process or procedure being performed by others. Examples
include observation of the counting of inventories by the entity’s personnel and observation of
the performance of control activities. Observation provides audit evidence about the performance
of a process or procedure, but is limited to the point in time at which the observation takes place
and by the fact that the act of being observed may affect how the process or procedure is
performed. (See ISA 501, “Audit Evidence – Additional Considerations for Specific Items” for
further guidance on observation of the counting of inventory).

iv. Inquiry
Inquiry consists of seeking information of knowledgeable persons, both financial and non-
financial, throughout the entity or outside the entity. Inquiry is an audit procedure that is used
extensively throughout the audit and often is complementary to performing other audit
procedures. Inquiries may range from formal written inquiries to informal oral inquiries.
Evaluating responses to inquiries is an integral part of the inquiry process.
Responses to inquiries may provide the auditor with information not previously possessed or
with corroborative audit evidence. Alternatively, responses might provide information that
differs significantly from other information that the auditor has obtained, for example,
information regarding the possibility of management override of controls. In some cases,
responses to inquiries provide a basis for the auditor to modify or perform additional audit
procedure.
The auditor performs audit procedures in addition to the use of inquiry to obtain sufficient
appropriate audit evidence. Inquiry alone ordinarily does not provide a sufficient audit evidence
to material misstatement at the assertion level. Moreover, inquiry alone is insufficient to test the
operation effectiveness of controls.
Although corroboration of evidence obtained through inquiry is often of particular importance, in
the case of inquiries about management intent, the information available to support
management’s intent may be limited. In these cases, understanding management’s past history of
carrying out its stated intentions with respect to assets or liabilities, management’s stated reasons
for choosing a particular course of action, and management’s ability to pursue a specific course
of action may provide relevant information about management’s intent.
In respect of some matters, the auditor obtains written representations from management to
confirm responses to oral inquiries. For example, the auditor ordinarily obtains written
representations from management on material matters when other sufficient appropriate audit
evidence cannot reasonably be expected to exist or when the other audit evidence obtained is of a
lower quality.

v. Confirmation
Confirmation, which is a specific type of inquiry, is the process of obtaining a representation of
information or of an existing condition directly from a third party. For example, the auditor may
seek direct confirmation of receivables by communication with debtors. Confirmations are
frequently used in relation to account balances and their components, but need not be restricted
to these items. For example, the auditor may request confirmation of the terms of agreements or
transactions an entity has with third parties. The confirmation request is designed to ask if any
modifications have been made to the agreement and, if so, what the relevant details are.

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Confirmations are also used to obtain audit evidence about the absence of certain conditions, for
example, the absence of a “side agreement” that may influence revenue recognition.

vi. Re-calculation
Recalculation consists of checking the mathematical accuracy of documents or records.
Recalculation can be performed through the use of information technology, for example, by
obtaining an electronic file from the entity and using CAATs to check the accuracy of the
summarization of the file.

vii. Re-performance
Re - performance is the auditor’s independent execution of procedures of controls that were
originally performed as part of the entity’s internal control, either manually or through the use of
CAATs, for example, re-performing the ageing of accounts receivable.

viii. Analytical Procedures

Analytical procedures consist of evaluation of financial information made by a study of plausible
relationships among both financial and non-financial data. Analytical procedures also encompass
the investigation of identified fluctuations and relationships that are inconsistent with other
relevant information or deviate significantly from predicted amounts
Examples of analytical procedures include the following:
• A comparison of payroll costs on a monthly basis taking account of wage rises, starters and
leavers and seasonal work
• A comparison of sales with expenses, on a monthly basis and as a comparison with prior years
• A comparison of the ageing stock or debtors on a monthly or quarterly basis and calculation of
debtor days or stock turnover

Analytical procedures are widely used but its usefulness is limited by such factors as the
predictability of relationships and the availability, relevance and comparability of information.
They are also limited by the auditor’s knowledge of the client’s business and the availability of
other types of evidence.

Reliability of Third Party Evidence

The auditor should determine whether the use of external confirmations is necessary to obtain
sufficient appropriate audit evidence. In making this determination, the auditor should consider
the assessed risk of material misstatement at the assertion level and how the audit evidence from
other planned audit procedures will reduce the risk of material misstatement at the assertion level
to an acceptably low level. The reliability of audit evidence is influenced by its source and by its
nature, and is dependent on the individual circumstances under which it is obtained.
Accordingly, audit evidence in the form of original written responses to confirmation requested
and received directly by the auditor from third parties who are not related to the entity being
audited, may assist in reducing the risk of material misstatement for the related assertions to an
acceptably low level.

Meaning of External Confirmation

External confirmation is the process of obtaining and evaluating audit evidence through a
representation of information or an existing condition directly from a third party in response to a

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request for information about a particular item affecting assertions in the financial statements or
related disclosures. In deciding to what extent to use external confirmations, the auditor
considers the characteristics of the environment in which the entity being audited operates and
the practice of potential respondents in dealing with requests for direct confirmation.
External confirmations are frequently used in relation to account balances and their components,
but need not be restricted to these items. For example, the auditor may request external
confirmation of the terms of agreements or transactions an entity has with third parties. The
confirmation request is designed to ask if any modifications have been made to the agreement,
and if so, what the relevant details are. External confirmations may also be used to obtain audit
evidence about the absence of certain conditions, for example, the absence of a “side agreement”
that may influence revenue recognition. Other examples of situations where external
confirmations may be used include the following:
a. Bank balances and other information from bankers;
b. Accounts receivable balances;
c. Stocks held by third parties at bonded warehouses for processing or on consignment;
d. Property title deeds held by lawyers or financiers for safe custody or as security;
e. Investment purchased from stockbrokers but not delivered at the balance sheet date;
f. Loans from lenders; and
g. Accounts payable balances.

The reliability of the audit evidence obtained by external confirmations depends, among other
factors, upon the auditor applying appropriate audit procedures in designing the external
confirmation request, performing the external confirmation procedures, and evaluating the results
of the external confirmation procedures. Factors affecting the reliability of confirmations include
the control the auditor exercises over confirmation requests and responses, the characteristics of
the respondents, and any restrictions included in the response or imposed by management.

Management Requests
When the auditor seeks to confirm certain balances or other information, and management
requests the auditor not to do so, the auditor should consider whether there are valid grounds for
such a request and obtain audit evidence to support the validity of management’s requests. If the
auditor agrees to management’s request not to seek external confirmation regarding a particular
matter, the auditor should apply alternative audit procedures to obtain sufficient appropriate audit
evidence regarding that matter. If the auditor does not accept the validity of management’s
request and is prevented from carrying out the confirmations, there has been a limitation on the
scope of the auditor’s work and the auditor should consider the possible impact on the auditor’s
report. When considering the reasons provided by management, the auditor applies an attitude of
professional scepticism and considers whether the request has any implications regarding
management’s integrity. The auditor considers whether management’s request may indicate the
possible existence of fraud or error. The auditor also considers whether the alternative audit procedures
will provide sufficient appropriate audit evidence regarding that matter.

Specific Examples of Third Party Confirmations

Commonly used external verification procedures are circularization of debtors, bank
confirmations, and confirmation of pending legal matters.
Debtors Circularization:

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Debtors’ circularization is a verification procedure whereby trade debtors are contacted directly
to confirm their balances. It is the normal means of checking whether the debtors really owe the
amount stated in the sales ledger of the client company. Many audit firms use debtors‟
circularization so extensively that they have developed standardized formats for the purpose.
Circularization should produce a written statement from each debtor contacted that the amount
owed at the date of the circularization is correct. This is reliable audit evidence, being from an
independent source, and in a documentary form. Circularization is essentially an act of the client,
who alone can authorise third parties to divulge information to the auditors. Should the client
refuse to co-operate in the circularization, the auditors will have to consider whether they should
qualify their audit report, as they may not be able to satisfy themselves, by means of other
procedures, the validity and accuracy of the debtors balances.
Ideally, the circularization should be done immediately after the year end to enable it cover the
year-end balances included in the Balance Sheet. Where time constraint would not make this
ideal timing possible, it may be appropriate and acceptable to carry out the circularization some
time prior to the year-end. It is recommended that prior year-end circularization should be done
not more than two months before the year-end. Prior year circularization may be appropriate in a
situation where the internal control system is strong enough to ensure that the circularization and
reconciliation of the movements in the sales ledger balances in the intervening period will
provide the auditors with reasonable assurance.

Bank Confirmations
Auditors rely heavily on bank confirmation for verification of completeness, existence, rights,
obligations and valuations of bank balance. The standard bank letter contains all items found to
be regularly required for audit purpose. In case of doubt, or specific requirement, auditors may
wish to make supplementary requests regarding other items which are not regularly required.
These may include the following:
i. copies of bank statement;
ii. copies of paying-in-slips for specified lodgement on specified dates;
iii. details showing make-up of those lodgements;
iv. any list of securities or any document of title which have been logged by a bank with its
customer us security for deposit with that bank (this particular matter would probably apply only
between banking organizations);
v. interest on any account paid to or by third parties, and the names of those third parties;
vi. receipts for fire and other insurance and similar documents in the banks possession;
vii. returned paid cheques;
viii. stopped cheques – these are normally presented through the banking system within the audit
period and therefore there should be no need to seek specific details;
ix. details of third party securities, including director’s guarantees. If this information is required,
the request must be accompanied by a specific authority from the appropriate third parties; and
x. details of outstanding forward foreign exchange contracts, including the particulars of each
contract, the dates of maturity and the currencies concerned.

Legal Confirmation -Pending Legal Matters

Confirmation will often be required from a client company’s legal advisors or solicitors
regarding contingent liabilities arising from legal matters outstanding at the balance sheet date.

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From the audit view-point, pending law suits and other actions and claims against the client
company may present problems both of ascertainment and appraisal
The following audit procedures are relevant for the verification of the existence of such claims,
(though they will not necessarily provide the auditor with adequate information on the likely
amounts for which the company may ultimately be responsible):
(a) Reviewing the claims system of recording claims and the procedure for bringing these to the
attention of the management;
(b) Discussing the arrangements for instructing solicitor’s with the official responsibility for
legal matters (for example, the head of the legal department, if any, or the company secretary);
(c) Examining the minutes of the board of directors or other relevant committee for references to
or indication of possible claims;
(d) Examining bills rendered by solicitors and correspondence with them;
(e) Obtaining a list of matters referred to solicitors from the appropriate director or official with
estimates of the possible ultimate liabilities; and
(f) Obtaining a written assurance from the appropriate director or official that he is not aware of
any matters referred to solicitors other than those disclosed.

In appropriate circumstances, auditors may decide to obtain written confirmations from third
parties of certain representations made by directors, for example the identification and appraisal
of contingent liabilities. In the field of legal actions, the normal and proper source of such
confirmation is the company’s legal advisors. Requests for such confirmations should be kept
within the solicitor – client relationship and the client should request that a copy of the reply
should be sent direct to the auditors.
In order to ascertain whether the information provided by the directors is complete, auditors may
decide to arrange for solicitors to be requested to advise whether they have matters in hand
which are not listed in the letter of request, and to provide information as to the likely amounts
involved. If the outcome of the enquiries set out above appears satisfactory, auditors would not
normally regard the absence of a corroboration of the completeness of a list of legal matters as a
reason in itself for qualifying their report. If the enquiries lead to the discovery of significant
matters not previously identified, the auditors will wish to extend their enquiries and to request
their clients to address further enquiries to, or arrange a meeting with, the solicitors, at which the
auditors will wish to be present. If however, having regard to all the circumstances, the auditors
are unable to satisfy themselves that they have received all the information they require for the
purpose of their audit, they must qualify their report.

Reliability of Audit Evidence

Consistency of audit evidence from different sources will have a collaborating effect, making the
evidence more persuasive where such evidence is inconsistent, the auditors must determine what
additional procedure are necessary to resolve the inconsistency. Auditors must consider the cost-
benefit relationship of obtaining evidence but any difficulty or expense is not in itself a valid
basis for omitting a necessary procedure. However, the reliability of audit evidence is influenced
by its sources (internal or external) and by its nature (Visual, documentary or oral). Some
generalisations may help in assessing that reliability. These are as stated below:
a) Audit evidence from external sources (e.g. confirmation received from a third party) is more
reliable than that obtained from the entity’s records;

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b) Audit evidence obtained from the entity’s record is more reliable when the related accounting
and internal control system operates effectively;
c) Evidence obtained directly by auditors is more reliable than that obtained by or from the
entity;
d) Evidence in the form of documents and written representations is more reliable than oral
representations; and
e) Original document are more reliable than photocopies, telexes or facsimiles.

Practice Questions

1. Write short notes on the following procedures for obtaining audit evidence
i. Inspection of records or documents;
ii. Physical Inspection of tangible assets;
iii. Observation;
iv. Inquiry;
v. Confirmation;
vi. Recalculation;
vii. Re-performance; and
viii. Analytical Procedures
2. Write short notes on the following: (a) Third party evidence (b) External confirmation (c)
Reliability of audit evidence

3. Write short notes on the following specific examples of external confirmation of audit
evidence: i. Debtor circularization ii. Bank confirmation iii. Legal confirmation