Chapter (3): Engagement Planning and Audit Evidence

Lecture (7)
Remember: Planning the Audit

Planning the Audit

1. Staff the Audit

2. Assess Materiality and 3. Outline the Audit
Engagement and Set a
Risk Procedures
Time Budget
3. Outlining the Audit Procedures to gather Evidence
Auditors use audit procedures to produce evidence about management’s assertions (Chapter 3)

As a rule, auditors use eight general audit procedures to gather evidence:

(1) Inspection of records and documents (vouching, tracing, scanning).
(2) Inspection of tangible assets.
(3) Observation.
(4) Inquiry.
(5) Confirmation.
(6) Recalculation.
(7) Reperformance.
(8) analytical procedures.
3. Outlining the Audit
1. Inspection of Records and Documents
Procedures to gather Evidence
• Much auditing work involves gathering evidence by examining authoritative documents prepared by
independent parties and by the client.
• Auditors frequently inspect such documents to ensure they contain the correct information and/or
authorization.
A. Documents Prepared by Independent Outside Parties
• The most reliable form of documentary evidence is external, which means that the document was received
directly from an independent outside third party (e.g., a bank).
• Examples of formal external documents include bank statements, title papers, and insurance policies
• Examples of ordinary external documents include vendor invoices, simple contracts, and written
correspondence.
• Regardless, when either type of document is received directly from an independent outside party, or from the
evidence is considered reliable. Eg Sales invoice
• In addition, a great deal of documentary evidence is considered external-internal, which means that the
documents were initially prepared by an external third party but they were received by the client first and then
given to the auditor.
• Since the client had possession of the documents, there is always a possibility that the client altered the
documents. As a result, external-internal documents are not as reliable as external documents.
3. Outlining the Audit Procedures to gather Evidence
B. Documents Prepared and Processed by the Client
• Documentation of this type is referred to as internal evidence.
• Some of these documents may be quite informal and not very authoritative or reliable.
• When such documents are prepared by the client but are mailed to third parties, they become slightly more
reliable.
• However, as a general proposition, the reliability of these documents depends on the quality of internal
control under which they were produced and processed.
• Because the client produces the evidence, an auditor must perform additional testing on this type of
information before placing any reliance at all on the internal evidence.
• Some of the most common of these documents are:

Internal Documents
1.Sales invoice copies 7.Shipping documents
2.Sales summary reports 8.Receiving reports
3.Cost distribution reports 9.Requisition slips
4.Loan approval memos 10.Purchase orders
5.Budgets and performance reports 11.Credit memos
6.Documentation of significant transactions with 12.Transaction logs
subsidiaries
Question (1): Determine which of the following is internal document or external document (whether
provided to the auditor by a totally external party or by through the client)

a) Receiving Report I
b) Customer Purchase Order I
c) Bank Statements received directly from the bank E
d) Copies of Sales Invoices I
e) Utility Bills E
f) Departmental Budget I
g) Insurance Policy E
h) Remittance Advice E
3. Outlining the Audit Procedures to gather Evidence
Tracing—Examination of Documents
• When testing the completeness assertion, the
auditor will take the tracing direction when
examining documents.
• When taking the tracing direction, the auditor
selects a basic source document and follows its
processing path forward to find its final recording
in a summary journal or ledger and ultimately the • In vouching, an auditor selects an item in the
financial statements.
• For example, samples of shipping documents can
be obtained from the warehouse and then traced to
sales invoices, the sales journal, and ultimately
their recording in the financial statements as
revenue earned.
• Using tracing, an auditor can decide whether all
significant transactions and events that should have
been recorded actually were recorded
(the completeness assertion)..
Vouching—Examination of Documents
• When testing the existence or the occurrence
assertion, the auditor will take the vouching direction
when examining documents.
• The important point about vouching is that the auditor
begins the search for evidence by focusing on
transactions that have already been recorded in the
financial statements.
financial records, usually from a journal or ledger,
and follows its path back through the processing steps
to its origin (i.e., the source documentation that
supports the item selected from the ledger).
• Consider a revenue entry made in the financial
statements. For that entry, the auditor will find the
journal entry, the sales summary, the sales invoice
copy, the shipping documents, and, finally, the sales
order from the customer. Vouching of documents can
help auditors decide whether all recorded significant
transactions are adequately supported.
3. Outlining the Audit Procedures to gather Evidence:
Vouching Vs. Tracing

Scanning—Examination of Documents
In general, scanning is an “eyes-open” approach of looking for anything unusual.
The scanning procedure usually does not produce direct evidence itself, but it can raise questions related to
other evidence that must be obtained. For example,
 accounts receivable balances for amounts over the credit limit,
 inventory quantities for negative balances or unreasonably large balances,
 payroll files for terminated employees,
 loan files for loans with negative balances,
 debits in revenue accounts and
 credits in expense accounts, to name a few.
3. Outlining the Audit Procedures to gather Evidence
2. Inspection of Tangible Assets
• Inspection of tangible assets includes examining property, plant, and equipment; inventory; and securities
certificates.
• Physical inspection of tangible assets provides compelling evidence of existence and may provide tentative
evidence of valuation. 
• For example, audit team members can verify the existence of specific pieces of equipment listed on the
client’s fixed asset register by locating them and noting their condition (valuation).
• However, inspection does not necessarily provide evidence that the entity owns the assets (rights). For
example, fixed assets on the client’s premises may be leased under operating lease agreements, and
inventory inspected by auditors may be held on consignment.
3. Observation
• Although inventory observation often refers to the physical inspection of inventory (i.e., tangible assets),
auditors use observation when they view the client’s physical facilities and personnel on an inspection tour,
when they watch personnel carry out accounting and control activities (such as observing client inventory
counts), and when they participate in a surprise payroll distribution.
• Observation also can produce a general awareness of events in the client’s offices. In this sense, observation
is commonly used as a test of controls.
3.4. Inquiry
Outlining the Audit Procedures to gather Evidence
• Inquiry is a procedure that generally involves the collection of verbal evidence from independent parties and
management (commonly referred to as written representations or management representations).

• Important inquiries and responses should be documented by the auditor in the workpapers.

• Auditors typically use inquiry procedures during the early planning stages of the engagement.

• E.g. questions regarding the number of employees, the addresses of the external warehouses, the name of
the external attorneys, the existence of any pending lawsuits.

• Evidence gathered by formal and informal inquiry generally cannot stand alone as convincing, and auditors
must corroborate responses with independent findings based on other procedures.

• In fact, the professional standards state that “inquiry alone” is never enough to reach an audit conclusion.
3. Outlining the Audit Procedures to gather Evidence
5. Confirmation
• Confirmation by direct correspondence with independent parties is a procedure widely used in auditing.
• It can produce evidence of existence and rights and obligations and sometimes of valuation and cutoff. 
• Auditors typically limit their use of confirmation to significant transactions and balances about which outside
parties could be expected to provide information.
• A selection of confirmation applications includes the following:
 Banks—cash and loan balances.
 Customers—receivables balances.
 Borrowers—note terms and balances.
 Agents—inventory on consignment or in warehouses.
 Policyholders—life insurance contracts.
 Vendors—accounts payable balances.
 Attorneys—litigation in progress.
 Lessors—lease terms.
• Confirmation letters are typically printed on the client’s letterhead and signed by a client officer; third parties
usually do not release information without client permission.
• Confirmation requests should seek information the recipient can supply, such as the amount of a balance or the
amounts of specified invoices or notes.

.
3. Outlining the Audit Procedures to gather Evidence
6. Recalculation
• Auditor recalculation of computations previously performed by client personnel produces compelling
evidence.
• A client calculation must always be mathematically accurate.
• Mathematical evidence can serve the objectives of existence and valuation for financial statement amounts
that exist principally as calculations, for example, depreciation, interest expense, pension liabilities, actuarial
reserves, bad debt reserves, and product guarantee liabilities.
• Recalculation, in combination with other procedures, is also used to provide evidence of valuation for all
other financial data.
7. Reperformance
• Although similar to recalculation, reperformance is much broader in approach.
• reperformance is commonly used by auditors while completing walkthroughs when gaining an understanding
of a client’s internal control system.
• In fact, reperformance can generally be completed for any client control procedure such as matching vendor
invoices with supporting purchase orders and receiving reports.
• Reperformance may be done either manually or computerized.
• An auditor, for example, can verify that an accounts receivable aging schedule was prepared properly by
sorting accounts receivable by due date.
3. Outlining the Audit Procedures to gather Evidence
8. Analytical Procedures
• Auditors can evaluate financial statement accounts by developing expectations about what an account
balance should be based on an analysis of relevant financial and nonfinancial data.

• When an auditor compares the expectation to a recorded balance, analytical procedures are being

performed.

• Auditors are required to use them when planning the audit and when performing the review of the financial
statements near the end of the audit before the audit report is issued.
3. Outlining
Analytical procedures takethe
the fiveAudit Procedures to gather Evidence
general forms
Analytical Procedures
1.Comparison of current-year account balances to
balances of one or more comparable periods
2.Comparison of current-year account balances to
anticipated results found in the company’s budgets and
forecasts
3.Evaluation of the relationships of current-year account
balances to other current-year balances for conformity
with predictable patterns based on the company’s
experience
4.Comparison of current-year account balances and
financial relationships (e.g., ratios) with similar
information for the industry in which the company
operates
5.Study of the relationships of current-year account
balances with relevant nonfinancial information (e.g.,
physical production statistics)
Sources of Information
Financial account information for
comparable period(s)
Example: Current-year cost of goods sold compared to
last year’s balance
Company budgets and forecasts
Example: Current-year cost of goods sold compared to
the company’s budgeted amount
Financial relationships among accounts in the current
period
Example: Relationship between inventory and cost of
goods sold
Industry statistics
Example: Comparing inventory and cost of goods sold
levels to comparable companies in the industry
Nonfinancial information such as physical production
statistics
Example: Comparing the number of unfilled orders to
inventory and cost of goods sold levels
Question (3): Materiality steps: For each of the following audit procedures determine what would have been the audit objective tested and the
type of evidence used while testing
Audit Objective Type of Evidence Audit Procedures
(Procedure)
    1. Watch client employees count inventory to determine whether company
Existence Observation procedures are being followed.
    2. Count inventory items and record the amount in the audit files.
Valuation Reperformance
    3. Trace postings from the sales journal to the general ledger accounts.
Completeness Tracing – Doc.
    4. Calculate the ratio of cost of goods sold to sales as a test of overall
Valuation Analytical Procedures reasonableness of gross margin relative to the preceding year.
    5. Obtain information about the client’s internal controls by asking questions of
Existence Inquiry client personnel.
    6. Trace column totals from the cash disbursements journal to the general ledger.
Completeness Tracing – Doc.
    7. Examine a piece of equipment to make sure a recent purchase of equipment
Existence Physical Inspection was actually received and is in operation.
    8. Review the total of repairs and maintenance for each month to determine
Analytical Procedures
Valuation whether any month’s total was unusually large.
    9. Compare vendor names and amounts on purchases invoices with entries in the
Completeness Tracing – Doc. purchases journal.
    10. Foot entries in the sales journal to determine whether they were correctly
Valuation Reperformance
totaled by the client.
    11. Make a surprise count of petty cash to verify that the amount of the petty cash
Valuation/Existence Physical Inspection
fund is intact.
    12. Obtain a written statement from the client’s bank stating the client’s year-end
Existence Confirmation
balance on deposit.
Question (3): classify the types of audit evidence into highly reliable , moderately reliable and least reliable

Reliability

High Medium Low

Physical Documentation Inquiry

examination
Analytical Observation
Reperformance procedures

Confirmation
Audit Documentation
• An engagement is not complete without preparation of proper documentation.
• Audit documentation is a written record of the basis for the auditor’s conclusions that provides the support
for the auditor’s representations, whether those representations are contained in the auditor’s report or
otherwise.
• The documentation (often referred to as workpapers despite that it is typically in electronic format) should
contain:
 support for the decisions regarding planning and performing the audit,
 procedures performed, evidence obtained,
 overall conclusions reached near the end of the audit.
• Even though the auditors legally own the audit documentation, professional ethics require that the files not be
transferred without the client’s consent because of the confidential information recorded in them.

• Documentation must be sufficient to enable an experienced auditor, having no previous connection with the
engagement, to understand the nature, timing, extent, and results of procedures, the overall conclusions reached
with respect to the area covered by the audit documentation, and the audit team member performing the work,
the date of work, the audit team member reviewing the work, and the date of review.
 Audit
Documentation

Permanent Files Temporary Files

E.g. Copies of the corporate or association charter, bylaws,

or partnership agreement, Copies of continuing contracts
such as leases, bond indentures, and royalty agreements,
Eg. the engagement letter, staff assignment notes,
history of the company, its products, markets, and
assessments of audit risks, and determination of
background,
audit materiality.
Question (2): Determine which of the following is a permanent and which is a temporary file to the auditor

a) Audit Planning memo T

b) Client organizational chart P
c) Prior year financial statements and audit reports T
d) Engagement letter T
e) Bank confirmations T
f) Schedule for current depreciation calculation T
g) Royalty agreements P
Covered today
• Types of Audit Evidence
• Types of Audit Documentation files
• Ranking of reliability of types of audit evidence .