Audit Evidence and specific considerations for certain items
Obtaining and documenting sufficient appropriate evidence on which to base the auditor’s opinion is one of the main objectives of an audit of financial statements and also an aspect in respect of which audit regulators in various jurisdictions find common problems when inspecting completed audit engagements.
Audit evidence and the objectives of an audit
The main objective of the work performed by the auditor in an audit engagement is that of obtaining reasonable assurance as to whether the financial statements, as a whole, are free from material misstatement, so that the auditor is able to express an opinion on the financial statements and report accordingly in the auditor’s report.
To obtain reasonable assurance about the financial statements, which is a high but not absolute level of assurance, the auditor needs to design and perform audit procedures to obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the auditor’s opinion.
ISA 500 Audit Evidence explains what the auditor’s responsibilities are in obtaining audit evidence that can underpin the auditor’s opinion and what constitutes sufficient appropriate audit evidence for such purpose.
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 like previous audits, provided that changes occurred in the meantime have been carefully taken into account, or a firm’s quality control procedures for 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, re-performance 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 acceptable low level the risk that the auditor could express an inappropriate opinion when the financial statements are materially misstated, and thus allowing 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 would be required, and by the quality of the evidence, where the higher the quality the less evidence may be 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 from its source, for instance whether it is generated by the client, a third party or the auditor, and from its nature, whereby documentary evidence is normally more reliable that 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 judgement that the auditor needs to establish. Professional judgement is not, however, an abstract and subjective category of the auditor’s frame of mind, as it should be informed by a structured approach to gathering evidence that is based on the assessed risks of material misstatement of the financial statements.
Designing and Performing Audit procedures for obtaining Audit Evidence
A number of ISAs, namely ISA 300, ISA 315 and ISA 330, require and explain that audit evidence should be obtained by performing risk assessment procedures and further audit procedures. Further audit procedures include tests of controls and substantive procedures, which in turn comprise tests of details and substantive analytical procedures.
In particular, alongside an overall audit strategy that indicates the scope of the work, the resources of staff allocated to specific areas and the timing of the engagement, a more detailed audit plan should indicate the audit procedures to be performed in respect of specific assertions in the financial statements and their timing.
The results of the initial risk assessment procedures, like the entity’s business risk assessment or the assessment of internal control, are the basis to design the nature, timing, and extent of further audit procedures to be performed in respect of the risks identified.
Further audit procedures should respond to the assessed risks of material misstatement at the assertion level, so that sufficient appropriate evidence can be obtained in respect of those risks.
The detailed audit plan records the risk assessment procedures and the further audit procedures at the assertion level in response to the assessed risks. The audit plan describes the nature, extent and timing of the audit procedures to be performed by team members in respect of specific classes of transactions, account balances and disclosures. In the case of an audit of a small entity the audit plan would normally be included in standard audit programmes and schedules used for the various transactions and account balances. In any case the standard programmes need to be tailored so that the approach to an item, in terms of the use of substantive procedures, tests of controls or both, is proportional to the risk assessed for that item and is directed at obtaining audit evidence capable of verifying the underlying assertions.
The audit evidence generated by the planned audit procedures should be sufficient and appropriate to support and corroborate, or to contradict, the management’s assertions in respect of specific classes of transactions, account balances or disclosures in the financial statements.
Audit procedures in respect of specific items in the financial statements should be designed with the objective of providing evidence capable of verifying the assertions embodied in an item so that the auditor can draw a reasonable conclusion about that item. Audit evidence and auditor’s conclusions in respect of the various assertions tested contribute to the overall audit evidence on which the auditor’s opinion is based.
The audit objectives in respect of the various assertions embodied in the financial statements, which need to be met by sufficient appropriate evidence provided by audit procedures, can be summarized as follows:
|Financial Statement Assertion||Audit Objective|
|Assertions about classes of transactions and events for the period under audit (usually profit and loss account assertions):|
|Occurrence||To form an opinion as to whether transactions and events that have been recorded have occurred and pertain to the entity.|
|Completeness||To form an opinion as to whether all transactions and events that should have been recorded have been recorded.|
|Accuracy||To form an opinion as to whether amounts and other data relating to recorded transactions and events have been recorded appropriately.|
|Cutoff||To form an opinion as to whether transactions and events have been recorded in the correct accounting period.|
|Classification||To form an opinion as to whether transactions and events have been recorded in the proper accounts.|
|Financial Statement Assertion||Audit Objective|
|Assertions about account balances at the period end (usually balance sheet assertions):|
|Existence||To form an opinion as to whether assets, liabilities, and equity interests exist.|
|Rights and obligations (Ownership)||To form an opinion as to whether the entity holds or controls the rights to assets, and liabilities are the obligations of the entity.|
|Completeness||To form an opinion as to whether all assets, liabilities and equity interests that should have been recorded have been recorded.|
|Valuation and allocation||To form an opinion as to whether assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.|
|Financial Statement Assertion||Audit Objective|
|Assertions about presentation and disclosure (covering both the profit and loss account and balance sheet):|
|Occurrence and rights and obligations||To form an opinion as to whether disclosed events, transactions, and other matters have occurred and pertain to the entity.|
|Completeness||To form an opinion as to whether all disclosures that should have been included in the financial statements have been included.|
|Classification and understandability||To form an opinion as to whether financial information is appropriately presented and described, and disclosures are clearly expressed.|
|Accuracy and valuation||To form an opinion as to whether financial and other information are disclosed fairly and at appropriate amounts.|
What information can be used as Audit Evidence?
When designing and performing audit procedures to verify assertions in the financial statements, the auditor should consider whether the outcome of the procedures would constitute relevant and reliable audit evidence.
Audit evidence would be relevant if it is capable of meeting the purpose of the audit procedure, which is normally that of verifying an assertion in respect of a financial statements item. The relevance of evidence produced by an audit procedure to a specific audit objective may also depend on the direction of testing. For instance when the objective of an audit procedure is that of testing for existence or valuation of accounts payable, testing the recorded accounts payable may produce relevant audit evidence. However when the audit objective is that of testing completeness (i.e. understatement) of accounts payable, testing the accounts payable already recorded would not be relevant, as it would be, for instance, testing subsequent payments, unpaid invoices and suppliers’ statements. Audit procedures may provide evidence that is relevant to certain assertions but not others. For example the inspection of documents in respect of the collection of receivables after the year end may provide relevant evidence about existence and valuation but not cut-off. However audit evidence from different sources or of a different nature may be relevant to the same assertion.
As already mentioned, the reliability of information to be used as audit evidence depends on its source and nature and the circumstances under which it is obtained. However in respect of audit evidence reliability, ISA 500 outlines a number of generalizations, some of which are:
- The reliability of audit evidence is increased when it is obtained from independent sources outside the entity.
- Audit evidence obtained directly by the auditor (for example, observation of the application of a control) is more reliable than audit evidence obtained indirectly or by inference (for example, inquiry about the application of a control).
- Audit evidence in documentary form, whether paper, electronic, or other medium, is more reliable than evidence obtained orally.
- Audit evidence provided by original documents is more reliable than audit evidence provided by photocopies or facsimiles, or documents that have been filmed, digitized or otherwise transformed into electronic form.
The generalizations above are however subject to relevant exceptions. For instance information obtained from an independent source outside the entity may not be reliable if the source is not knowledgeable. Similarly a management’s expert may lack objectivity.
Documentation of Procedures and Audit Evidence
Audit procedures designed and performed by the auditor should clearly document the audit objective that they intend to achieve (in terms of assertions relating to a specific class of transactions, account balance or disclosure), the actual work performed, the results obtained, their evaluation and a conclusion as to whether the audit evidence obtained is sufficient and appropriate to verify or not the assertion and is capable of supporting the auditor’s opinion.
The documentation of the design and performance of audit procedures may take place by using free form working papers, especially when documenting uncommon procedures or procedures in respect of specialist items, like defined benefit pension plans, or by using structured working papers like those included in audit programmes, which also suggest audit objectives and standard procedures in respect of the most common financial statements items. As ever when using audit programmes, the auditor should only select relevant procedures and documentation according to the risk assessment in that area of the financial statements, the materiality assessment, and the extent to which the auditor wishes to rely on directional testing. Additionally standard audit tests may need to be varied or substituted by more efficient non-standard tests that are better suited to the nature of the client and the systems employed.
Obtaining Audit Evidence in respect of some specific Items
Audit regulators in various jurisdictions find a number of common problems when conducting external inspections of completed audit engagements.
A general problem encountered is that audit files fail to meet the ISAs requirements as they fail to record sufficient appropriate audit evidence to support the auditor’s conclusions and opinion. It may happen that the audit working papers do not record adequate details of the audit procedures performed and of the conclusions drawn from the audit work carried out. In such a case it would not be possible to determine from the documentation what audit objective was to be achieved by the work done, what procedures were performed and what results were actually obtained.
The problem in respect of audit evidence normally stems from the fact that either the work set out in the audit plan has not been completed or that the auditor has not recorded the work undertaken in an effective manner. Therefore, in the first case the auditor would have failed to meet the requirements of ISA 500 in respect of obtaining sufficient appropriate audit evidence on which to base the auditor’s opinion, whilst in the second case the requirements of ISA 230 Audit Documentation would not be met as the documentation does not record all the matters which are significant in supporting the auditor’s opinion.
It goes without saying that if the auditor has not performed the work planned there would be no grounds to express an opinion on the financial statements. If on the other hand the auditor has been unable to produce effective documentation of procedures and audit evidence, the recommendations above as to the form and content of effective documentation should be followed.
Apart from the general problem relating to recording sufficient appropriate audit evidence, which could imply a systematic failure across the whole audit engagement in obtaining and recording audit evidence, the audit regulators commonly come across issues relating to the inappropriate approach to the audit of specific items in the financial statements, which may be unsuitable to generate sufficient appropriate audit evidence and for which guidance may be derived from ISAs and established audit practice.
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.
ISA 501 therefore focuses on the existence assertion, i.e. testing for overstatement of inventory, and on the condition of inventory, which is relevant to its valuation by identifying obsolete, damaged and slow moving items, both of which should invariably be verified by attending and performing audit procedures at the inventory counting.
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.
Company directors, i.e. those charged with its governance, are responsible for preparing financial statements that are free from material misstatement and of ensuring that the amount at which inventory is recorded in the financial statements represents inventory physically in existence and includes all inventories of the entity. To achieve this, entities may maintain detailed records of inventory and check these by regular test counts, a perpetual inventory system. In some entities where the accounting records are less detailed, the amount of inventory may be determined by way of a full physical count at a date close to the entity’s financial year end.
Where an entity maintains a perpetual inventory system, checked by regular test counts, the auditor should perform procedures to confirm whether adequate records of inventory are maintained and kept up-to-date, procedures for inventory recording and test-counting are satisfactory and all material differences between the book records of inventory and the physical counts are investigated and corrected. The auditor attending a physical inventory counting for such an entity will need to consider whether the checking of stocks as a whole is effective in confirming that accurate records of inventory are maintained.
For entities that do not maintain detailed records of inventory and rely on a full physical count around the financial year end, the auditor’s attendance at the inventory counting is more important for the purpose of obtaining audit evidence in respect of inventories.
When the auditor attends an inventory count in compliance with ISA 501, the auditor is required to:
- Evaluate management’s instructions and procedures for recording and controlling the results of the entity’s physical inventory counting;
- Observe the performance of management’s count procedures;
- Inspect the inventory; and
- Perform test counts.
The auditor should examine the way the inventory count is organised and evaluate the adequacy of management’s instructions; for example as to whether they address the accurate identification of slow moving, obsolete or damaged items or control over the shipping and receipt of inventory before and after the cut-off date. Such instructions should be preferably in writing and should cover all phases of the inventory counting procedures.
During the inventory counting the auditor should observe whether the entity’s staff are carrying out management’s instructions and count procedures properly, and if that is not the case, any issues identified should be brought to the attention of the management supervising the counting, including a request to re-perform partly or completely the count.
The inspection of the inventory and the performance of test counts assists the auditor in ascertaining the existence of inventory and in identifying obsolete, damaged or ageing items. Test counts should also be designed to provide audit evidence in respect of completeness of inventory and intrinsically provide evidence about the accuracy of the inventory count records.
Common problems encountered by audit regulators in respect of the audit of inventory include the fact that the inventory count is not attended or that the evidence of the work done during attendance at the inventory count is poor. Frequently attendance notes do not provide sufficient detail of what happened on the day. To rectify this issue, there should be adequate notes that provide a reasonable outline of the procedures performed. In particular it is important to record clearly which lines of inventory have been counted during the test counts and to indicate the direction of the test.
When carrying out test counts the auditor should select items from the count records and trace them back to the physical inventory. Such a procedure, coupled with inspection of the selected items, has the objective of verifying the existence of inventory and its physical condition. When using a judgemental approach to the selection of items, the auditor should give particular consideration to those inventories which the auditor believes to have a high value, either individually or as a category, and to those that are susceptible to misappropriation.
Conversely the auditor should select items from the physical inventory and count them back to the inventory count records. In this case the direction of the testing will have the objective of verifying completeness of inventory, i.e. that inventory is not understated.
Apart from relying on inspection of selected items during test counts, the auditor may verify the condition of inventory also by observing whether the management’s procedures for identifying damaged, obsolete and slow moving items operate properly.
The work performed to corroborate that inventory is correctly valued will normally involve verification of the cost of inventory and of its net realisable value. When testing cost it will normally be necessary to look at suppliers’ invoices and similar documentation. In particular a sample of items from the count records may be selected and agreed to purchase invoices from suppliers to verify the cost. If standard costs have been used then the standard costing calculations will need to be reviewed and tested. Net realisable value testing will involve looking at the after date sales invoices and, if necessary, testing the number of units sold at such price. The test that may be performed in this case would involve selecting items from the count records and agreeing them to the sales invoices.
During attendance at the inventory count the auditor may obtain cut-off information, such as details of the movement of inventory, to assist the auditor in performing audit procedures over the accounting for such movements at a later date. Where possible, cut-off testing for inventory can be combined with the same testing for sales and purchases.
When the physical inventory counting takes place at a date which is not the financial statements date, the auditor will also need to perform procedures to obtain audit evidence about whether changes in inventory between the count date and the date of the financial statements are properly recorded. In such a case the auditor evaluates the effectiveness of controls over changes in inventory to determine whether the conduct of inventory counting at a different date is appropriate for audit purposes. The observation of entity’s cut-off procedures and cut-off testing performed by the auditor will be relevant in these circumstances.
If the auditor is unable to attend physical inventory counting due to unforeseen circumstances, the auditor shall make or observe some physical counts on an alternative date, and perform audit procedures on intervening transactions.
If attendance at physical inventory counting is impracticable, ISA 501 requires the auditor to perform alternative audit procedures to obtain sufficient appropriate audit evidence regarding the existence and condition of inventory. If it is not possible to do so, the auditor shall modify the opinion in the auditor’s report in accordance with ISA 705.
It has to be noted that ISA 501 contemplates only limited circumstances when the auditor’s attendance at inventory counting may be considered impracticable, mainly relating to the fact that the nature and location of the inventory may pose threats to the safety of the auditor. If attendance is just generally inconvenient for the auditor that would not make it impracticable. Therefore, as explained in ISA 200, question of difficulty, time or cost involved would not in itself be a valid basis for the auditor to omit an audit procedure for which there is no alternative or to be satisfied with audit evidence that is less than persuasive, as it might be the case if the inventory counting is not attended.
In the limited cases where attendance at inventory counting is impracticable, alternative audit procedures, like inspection of documentation of the subsequent sale of specific inventory items, acquired or purchased prior to the inventory counting, may provide sufficient appropriate audit evidence about the existence and condition of inventory. However, when performing alternative procedures would not be suitable in providing sufficient appropriate audit evidence in respect of inventory, the auditor should, in accordance with ISA 705, modify the opinion in the auditor’s report as a result of the scope limitation.
In the circumstances in which the entity does not undertake any physical inventory counting and does not maintains a perpetual inventory system, i.e. when it does not have any meaningful internal control on inventory that is necessary for the preparation of financial statements that are free from material misstatement, the preconditions for an audit indicated in ISA 210 Agreeing the terms of audit engagements may not be present. In such a case the auditor should consider whether it is appropriate to accept or continue the audit engagement for such an entity.
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.
It will normally be necessary to test a sample of sales ledger balances to verify their existence and this could be done by using a variety of procedures. A common and effective procedure is that of tracing and agreeing the balances selected to after date cash received. When a judgemental method of selection is used older and larger balances should be covered.
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.
It is also important to appreciate that a debt that has been confirmed to exist will not necessarily be recovered, and therefore the valuation objective is not met simply by a debtor confirming to the auditor that the debt existed at the year end. Testing selected items against after date cash receipts is a procedure that is also relevant in verifying recoverability of receivables; however the objective is normally achieved by using a combination of procedures. In particular the use of analytical procedures can provide evidence to compound the results of the tests on after date cash receipts. For example, comparing the bad debt expense as a percentage of sales and the provisions for unrecoverable accounts as a percentage of receivables to the data of the previous year may corroborate the receivables’ valuation. Similar evidence may be derived by comparing receivables’ turnover and receivables’ days to the previous year or by examining large customer accounts individually and comparing them to the previous year’s balances. Another procedure to verify valuation of receivables is the examination of credit notes issued after the year end for provisions that should be made against current year balances.
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.
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.
Addressing the completeness objective for payables is not easy and should be approached from two angles: assessing whether the list of creditor balances includes all payables existing at the year end, and assessing whether each creditor balance recorded is complete in respect of all transactions up to the year end.
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.
The use of direct confirmation using a payables circularisation is also an option to confirm completeness and valuation although it is less commonly utilised in practice given that it yields levels of returns, and therefore evidence, that is lower than that obtainable from suppliers’ statements.
The use of analytical procedures can also be very relevant for the objective of verifying completeness and valuation, for example the auditor’s background knowledge of the client may indicate the major suppliers that would be expected to be present in the list of payables at the year end. The auditor may therefore compare the list of balances with those outstanding at the previous year end and also consider the main suppliers during the year (by reviewing an activity report), and ensure that there is a realistic balance outstanding at the year-end for each of them.
The main objectives when auditing income are those of verifying completeness, i.e. that income is not understated, accuracy and cut-off, i.e. 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, i.e. 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.
Tests of controls are never sufficient on their own to provide sufficient appropriate evidence in respect of material balances or classes of transactions and therefore substantive procedures are necessary when auditing income.
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.
The direction of the test, i.e. verifying completeness of recording in the sales ledger, dictates that selecting a sample from the ledger or from the sales invoices would not be relevant to the objective as the sample would not include what has not been recorded. It follows that verifying income by reconciling nominal ledger balances to VAT returns does not yield evidence in respect of completeness.