Question

What are the different ways to obtain audit evidence? Can you give examples of each? What does it mean for audit evidence to be sufficient and appropriate, and why is it necessary?

Answer 1

• Audit procedures for obtaining audit evidence

The evidence-gathering process involves the following steps:

1. designing the audit procedures or tests;
2. carrying out the audit procedures or tests and/or gathering evidence;
3. analyzing evidence and drawing conclusions, which may also involve evaluating performance against the audit criteria; and
4. making decisions about whether additional information is required and can be obtained (go back to step 1) or whether sufficient appropriate evidence exists.

Audit procedures typically focus on the key risk areas identified through a risk analysis.

It is not unusual for audits to be redesigned during the examination stage as teams encounter unforeseen difficulties in gathering sufficient evidence of appropriate quality. Auditors have to be alert to any signs that the evidence-gathering process may not be achieving the level of assurance required for the audit assignment and take appropriate corrective action. If there are any potential amendments to the audit program, communicate these changes and raise any other issues, on a timely basis, with the senior members of the audit team. In instances where modifications did not take place before the start of field work, modify the audit steps as the work progresses, obtain approval for changes to audit programs, and include appropriate information on the nature, timing, and extent of steps to be performed.

• Sufficient appropriate audit evidence

A large part of the work involved in the performance of an audit consists of obtaining and evaluating audit evidence, which is primarily derived from audit procedures carried out during the course of the engagement, but that can also be gained from other sources. For example sources like previous audits; provided that changes occurred in the meantime have been carefully taken into account; or the firm’s quality control procedures, especially around client acceptance and continuance.

Audit procedures that are used to obtain audit evidence are various and are often applied in combination. They can include inspection, observation, confirmation, recalculation, reperformance and analytical procedures, in addition to inquiry, as the latter does not normally provide sufficient audit evidence on its own.

However, audit evidence obtained will only be useful in reducing to an acceptably low level the risk that the auditor could express an inappropriate opinion when the financial statements are materially misstated and, therefore, allow the auditor to draw reasonable conclusions, when it is sufficient and appropriate to the circumstances.

Sufficiency and appropriateness of audit evidence are two qualities that are interrelated. Sufficiency is the measure of the quantity of audit evidence. The quantity of audit evidence needed is affected by the risks of misstatement assessed by the auditor, whereby the higher the risks the more audit evidence required, and by the quality of the evidence, where the higher the quality the less evidence perhaps required. A large amount of audit evidence may, however, not compensate for its poor quality.

Appropriateness is the measure of the quality of audit evidence. The quality of audit evidence depends on whether it is relevant and reliable in providing support to the conclusions on which the auditor’s opinion is based. Whether evidence is reliable also depends on its source; for instance, whether it is generated by the client, a third party or the auditor; and also from its nature, whereby documentary evidence is normally more reliable than verbal evidence.

Whether the audit evidence obtained in the course of an engagement is sufficient and appropriate to support the auditor’s opinion is a matter of professional judgment that the auditor needs to establish. Professional judgment is not, however, an abstract and subjective category of the auditor’s frame of mind, and should be informed by a structured approach to gathering evidence that is based on the assessed risks of material misstatement of the financial statements.

• Brief examples of some audit evidences in respect of some items:

1. Inventory

The main assertions in the financial statements relating to inventory are existence, ownership, completeness and valuation and audit procedures should be designed and performed with the objectives of verifying such assertions.

ISA 501, Audit Evidence – Specific Considerations for Selected Items, deals with inventory and specifically requires that, if inventory is material to the financial statements, the auditor shall obtain sufficient appropriate audit evidence regarding the existence and condition of inventory by, in addition to other procedures, attendance at physical inventory counting unless impracticable.

Attendance at the inventory counting is in any case also relevant in providing evidence in respect of the completeness and valuation of inventory and in respect of the cut-off for recording inventory inwards and outwards movements, and the connected impact on revenues and costs.

When the auditor attends an inventory count in compliance with ISA 501, the auditor is required to:

1. Evaluate management’s instructions and procedures for recording and controlling the results of the entity’s physical inventory counting;
2. Observe the performance of management’s count procedures;
3. Inspect the inventory; and
4. Perform test counts.

• 2.Receivables

The main audit objectives that should be addressed when auditing assertions in respect of receivables are:

• Verifying that the receivables exist at the financial statements date;
• Verifying that receivables are accurately recorded at the correct value and provisions are made for bad and doubtful debts;
• Verifying completeness of receivables and cut-off.

When the auditor knows that the amount of after date cash received will be limited due to the level of receivable days, which may stretch beyond the audit engagement completion date, other procedures should be considered, like circularisation of balances on an earlier period with roll forward of the amounts, substantive analytical procedures or obtaining evidence that goods sold were received by or dispatched to the customer before the year end

Completeness and cut-off of receivables is normally tested in conjunction with sales and inventory. The objective is to verify that sales and receivables are completely and accurately recorded and are accounted for in the correct period, and that the inventory treatment is consistent with the timing of the sale. A procedure for verifying completeness is that of tracing a sample of dispatch documentation to sales invoices and into the sales and receivables ledgers. Cut-off testing may be performed by selecting a sample of sales invoices around the year end (before and after), inspecting the dates and comparing them with the dates of dispatch of goods in the relevant documentation and with the dates recorded in the ledger for application of correct cut-off. Another cut-off procedure is that of reviewing material after-date invoices and credit notes and ensuring that they are recorded in the correct period. It has to be noted that cut-off testing should not be performed by reference to invoices only, as sales should be recognised in accordance with the applicable revenue recognition policies that would often refer to the date when goods are dispatched; there could be in fact a discrepancy between the date of the invoice and the date the sale should be recognised. Analytical procedures, for instance comparing the gross profit percentage by product line to the previous year, may also provide evidence of completeness and cut-off for sales and receivables.

• 3.Payables

The audit objectives that should be addressed when auditing assertions in respect of payables are verifying the completeness, accuracy and valuation of liabilities as often there is a specific risk that payables are not completely recorded in the accounts, particularly where there is doubt about the entity’s ability to continue trading or when there are pressures on the entity to meet certain profit targets.

An effective procedure to verify completeness and valuation is that of reconciling a sample of accounts payables with suppliers’ statements. Many suppliers provide monthly statements to their customers and these may therefore be available for examination. Such statements are documentary evidence originating from outside the entity and therefore are an independent and reliable source of evidence. In any case the auditor should be aware that such statements may have been tampered with by the entity and, in case of doubt, the auditor should request a copy directly from the supplier.

• 4.Income

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The main objectives when auditing income are those of verifying completeness, ie that income is not understated, accuracy and cut-off, ie that all items are recorded in the correct period.

As mentioned above, income should be recorded in accordance with the applicable and appropriate revenue recognition policy of the entity, which would often result in recognition of sales when goods are dispatched or services supplied to customers.

Effective auditing of income requires a satisfactory understanding of the entity’s systems, ie what systems are in place and what documentation is produced to control the dispatch of goods or the provision of services. When the entity has in place a sales system that includes controls to ensure that all sales have been recorded, the auditor could perform tests of controls to obtain evidence about its effectiveness in detecting and correcting material misstatement. The sales system should be documented by the auditor and, if judged effective following tests of controls, it may enable a reduction in the performance of substantive procedures.

Analytical procedures are important in testing completeness of income and may be used in place or in combination with tests of details. For such purpose the auditor may compare the level of sales over the year, on a month-by-month basis, with the previous year or reconcile the total quantities of goods bought and sold. The auditor may also analyse the effect on sales value of changes in quantities sold, or of changes in products or prices. The auditor should also record reasons for changes in gross profit margin, ideally broken down by product area and month or quarter, as that would provide relevant evidence of completeness of income.

In addition to analytical procedures, the auditor may carry out a directional test on completeness of recording of individual sales in the accounting records. For such purpose the test should start with a sample taken from the evidence that the supply has taken place, rather than a sample taken from sales invoices. The documents that first record that a supply has taken place, like goods dispatched notes or till rolls, should be traced back, also via intermediate documents, to the sales ledger. The completeness of the documents that first record a supply should also be verified by, for instance, checking the sequence of goods dispatched notes.