Chapter-Five

Audit Evidence decisions and

documentation
 Audit evidence
• Is the information obtained by the auditor in arriving at
conclusions on which their reports are based.
• During financial statement audits, the auditors gather and
evaluate evidence to form an opinion about whether the
financial statements follows the appropriate criteria, usually,
generally accepted accounting principles.
• The audit evidence is intended to assure the users of accounting
information that the financial statements are a credible source
of information about the organization.
 Sufficient competent evidential matter is to be obtained through
inspection, observation, inquires, and confirmation to afford a
reasonable basis for an opinion regarding the financial
statements under audit. The evidence collected by the auditor
must be sufficient and appropriate.
Cont…
 The nature of assertions for which the auditor collects evidences for an independent financial
audit is the following
• Existence: the inclusion of an item of asset or liability in the balance sheet implies an assertion by
the preparer that the asset or the liability exists at the date of the balance sheet.
• Rights and obligations: it is asserted that the assets shown in the balance sheet are the rights
of the organization and liabilities are the obligations on the date of the balance sheet
• Occurrence: there is an assertion that the transactions reflected in the financial statements are
occurred during the relevant accounting period and that they pertain to the organization.
• Completeness: this assertion implies that there are no unrecorded assets, liabilities or
transactions.
• Valuation: this assertion implies that the assets and liabilities are included in the balance sheet
are at an appropriate value i.e. as per the normally accepted bases of valuation.
• Measurement: this assertion implies that transactions have been recorded at proper amounts
and that revenues and expenses have been allocated to the proper accounting periods
• Presentation and disclosure: this assertion implies that the disclosure, classification and
description of various item in the balance sheet and in the income statements are in accordance
with the generally accepted accounting standards and relevant statutory requirements
 5.1 Audit Evidence Decisions

Major decision of an auditor involves determining the appropriate type and amount of evidence. In this judgment
the cost factor should be considered.
 The auditors' decisions on evidence accumulation can be broken down in to four sub decisions:
1. Which audit procedure to use (Audit Procedure?)
2. Which sample size to select for a given procedure (Sample Size?)
3. Which items to select from population (Items??)
4. When to perform the procedures (Timing)

1. Audit procedures-It is a detailed instruction for the collection of a type of audit evidence that is to be obtained at
some time during the audit. The instructions should be clearly and specifically stated.
 Example: - Obtain cash disbursement journal and compare the payer name, amount, and date on the cancelled
cheque with cash disbursement journal.
2. Sample Size- After selection of audit procedure, the decision of how many items to test must be made by the
auditor for each audit procedures.
 Example: - If 60,000 checks are recorded in cash disbursement journal, only 400 may be selected.
3. Items to Select- Following the sample size selection, it is necessary to decide which items in the population to
test.
 Example: - The auditor may see the 400 checks based on random selection, weakly selection, amount etc.
4. Timing- The timing decision is affected by when the client needs the audit to be completed. Also, it can be
affected by the auditors' belief on effective timing for accumulation and the availability of audit staff.
 Example:- the auditor often prefer to count inventory up close to the balance sheet dates.

The audit procedure often incorporates the other three sub decisions.
 Example: - obtain the October cash disbursement journal and compare the payee, name, amount, and date on
 5.2: NATURE OF EVIDENTIAL MATTER

• Evidential matter is any information that corroborates or refutes an assertion. The

evidential matter supporting the assertions in a company’s financial statements
consists of the underlying accounting data and all corroborating information available
to the auditors.
• The two determinants of the persuasiveness of audit evidence are competence and
sufficiency.
a) Competence of evidence
This refers to the extent to which evidence can be believable or worthy of trust;
sometimes reliability is interchanged with competence.
 Competence of evidence deals only with the audit procedures selected.
 selecting larger sample size or different population items.
 It can be improved only by selecting audit procedures that contain higher quality of
characteristics of competent evidence.
b) Sufficiency of evidence
This refers to the quantity of evidence. It is primarily measured by the sample size. The
selection of sample size is determined at least by:
• Auditor's expectations of misstatement
•
 Characteristics of competent evidence

• Relevance: - Evidence must be relevant to specific audit

objective.
For example if the auditor is interested to examine sales
transaction, the evidences gathered must be related to sale.
• Independence of provider: - Evidences obtained outside the
client company is more reliable than that obtained from
with in.
• Effectiveness of client's internal control: - Strong internal
control systems produce more reliable evidence than
weaker ones.
• Auditor's direct knowledge: - Information obtained directly
by the auditor through physical examination, observation
and computation are more competent.
 3.2. TYPES OF AUDIT EVIDENCES
• Physical evidence: Actual physical examination or observation provides the best evidence of the
existence of certain assets.

• Documentary evidence: Another types of evidence relied upon by the auditor is the
documents.

• Accounting records as evidence: the dependability of ledgers and journals as evidence is

indicated by the extent of internal control covering their preparation.

• Evidence from the analytical procedures: analytical procedures involve

evaluations of the financial statements by a study of relationships among financial and nonfinancial data.

• Evidence from client representation letters: The auditor should get a

representation letter from the client summarizing the most important oral representations made during the
engagement.

• Evidence provided by the specialists: since the auditors may not be experts in all
the fields of business of the client, he may get the services of the experts in performing highly technical tasks such as
valuation of inventory, or making the actuarial computations to verify liabilities for postretirement benefits. The expert
should be independent person

• Oral evidence: during the examination of records, the auditor may ask many questions to the officers and
the employees of the organization on the endless topics ranging from the location of records and documents

• Evidence from computations: to prove the arithmetical accuracy of the client’s records,
 5.4 EVIDENCE FOR RELATED PARTY TRANSACTIONS
 Related parties refer to the client entity and any other party
with which the client may deal where one party has the
ability to influence the other to the extent that one party to
the transaction may not pursue its own separate interests.
Examples of related parties are officers, directors, principal
owners, members of the immediate families, affiliated
companies, subsidiary companies etc. A related party
transaction is a transaction between the company and these
parties.
• though the making of estimates are the responsibility of the
management, the auditor should determine that
– All necessary estimates have been developed
– The accounting estimates are reasonable and
– The accounting estimates are properly accounted for and disclosed
 5.5. The relationship of audit risk and audit evidence

Audit risk-refers to the possibility that the auditors may unknowingly fail to
appropriately modify their opinion on financial statements that are materially
misstated. In other words, it is the risk that the auditors will issue an
unqualified opinion on financial statements that contain a material departure
from generally accepted accounting principles.
• The first risk, the risk of occurrence of a material misstatement, may be
separated into two components-inherent risk and control risk. The risk that
auditors will not detect the misstatement is called detection risk.
• Inherent Risk- The possibility of a material misstatement of an assertion
before considering the client’s internal control is referred to as inherent risk.
Factors that affect inherent risk related to either the nature of the client and
its industry or to the nature of the particular financial statements account.
• Control risk- The risk that a material misstatement will not be prevented or
detected on a timely basis by the client’s internal control is referred to as
control risk. This risk is entirely based on the effectiveness of the client’s
internal control.
 5.5. The relationship of audit risk and audit evidence

• Detection risk-The risk that the auditors will fail to

detect the misstatement with their audit procedures
is called detection risk. In other words, detection risk
is the possibility that the auditors’ procedures will
lead them to conclude that material misstatement
does not exist in an account or assertion when in
fact such misstatement does exist.
Detection risk is restricted by performing substantive
tests. For each account, the scope of the auditors’
substantive tests, including their nature, timing and
extent determines the level of detection risk.
5.5. The relationship of audit risk and audit evidence
• * The bag of sand in the figure represents inherent
risk, the susceptibility of an account balance to
material misstatements.
• * The sieves represent the ways by which the
client and the auditors attempt to remove the
misstatements from the financial statements.
• The first sieve represents the client’s internal
control, and the risk that it fails to detect or
prevent a misstatement is control risk.
• The auditors’ audit procedures are represented by
the second sieve, and the risk that it will fail to
detect a misstatements is detection risk. The risk
that the misstatement wills get through both sieve
is audit risk.
• Measuring audit risk- In practice, the
various components of audit risk are not typically
quantified. Instead, the auditors usually use
qualitative categories, such as low risk, moderate
risk, and maximum risk.
• Statements of Auditing Standards (SAS-47), allows
the use of either quantified or non quantified
approach.
 Audit Risk Model for Planning

• The audit risk model expresses the relationship between the audit risk
components as follows:
AR = IR x CR x DR
• The symbols represent audit, inherent, control, and detection risk. The
model can be used to determine the planned detection risk for an
assertion.
• To illustrate the use of the model, let’s assume that the auditor has
made the following risk assessments for a particular assertion, such as
the valuation or allocation assertion for inventories;
• IR = 50%; CR = 50%
• Further, let’s assume the auditor has specified an overall AR of 5%.
Detection risk can be determined by solving the model for DR as follows:
• DR = AR 4- (IR x CR) = 5% (50% x 50%) = 20%
• In practice, many auditors do not attempt to quantify each risk
component, making it impossible to mathematically solve the risk
• In any way, the relationships among audit risk, inherent risk, control risk,
and detection risk can be put generally as follows:
AR=IR×CR×DR , where, AR = Audit risk
IR = Inherent risk
CR = Control risk
DR= Detection risk
• To illustrate how audit risk may be quantified, assume that auditors have assessed inherent
risk for a particular assertion at 50% and control risk at 40%. In addition, they have
performed audit procedures that they believe have a 20% risk of failing to detect a material
misstatement in the assertion. The audit risk for the assertion may be computed as follows:
AR = IR × CR × DR
= .50 × .40 × .20
=.04
• Thus, the auditors face a 4% audit risk that a material misstatement has occurred and
evaded both the client’s controls and the auditors’ procedures.
• It is important to realize that while auditors gather evidence to assess inherent risk and
control risk, they gather evidence to restrict detection risk to the appropriate level.
• Inherent risk and control risk are a function of the client’s nature of internal control
structure and its operation environment.
• Therefore, evidence gathered by the auditors is used to assess the levels of inherent and