Chapter Five: Audit evidence and Audit planning

5.1: Audit Planning And Essentials Of Audit Planning

5.2: Nature Of Audit Evidence
5.3: Types Of Audit Evidence And Features Of Reliable
Audit Evidence
5.4: Audit Working Paper And Audit Documentation
5.6: Types Of Audit Risk
5.1. Audit planning and its essentials

 Audit Planning means to think in advance before work is

performed.
 It involves making decisions about the work to be carried
out.
 Audit planning requires making decisions about whether to
accept a client for audit in the first place and this is called
pre-engagement planning.
 Once the engagement is accepted, audit planning involves
making decision about specific steps that help determine an
over all audit strategy and this is called engagement
planning.
Audit planning and its essentials

 Adequate planning and supervision is the first and the important

auditing standards of field work.
 An audit plan is a broad overview of an audit engagement
prepared in the planning stage of the engagement.
 The first standard of field work states: “The work is to be
adequately planned and assistants, if any, are to be properly
supervised.”
 The concept of adequate planning includes investigating a client
before deciding whether to accept the engagement, obtaining an
understanding of the client’s business operations, and developing
an over all strategy to organize, coordinate and schedule the
activities of the audit staff.
 DISCUSSION
Discuss why adequate audit planning is essential.
Reasons for Audit planning 
Auditors have to plan their audit work carefully before simply entering
in to it. Audit panning is required because it helps the auditors:
1. To weight the risks and rewards of taking on a new client in the
case of pre-engagement planning
2. To obtain knowledge of the nature of the client’s business so
that appropriate attention is devoted to important areas of the audit.
3. To identify the potential problems in advance and deal with them
effectively.
4. To ensure that sufficient and competent evidence is obtained
5. To complete the work expeditiously by controlling costs and to
meet important dead lines
6. To properly assign work to assistants and coordinate work carried
out by other auditors and experts.
Planning an Audit and Designing an Audit Approach

Although the audit plan differs in form and content among public accounting firms, a
typical audit plan includes the following:
1. Accept client and perform initial audit planning.
2. Understand the client’s business and industry
3. Assess client business risk.
4. Set materiality and assess acceptable audit risk and inherent risk.
5. Understand internal control and assess control risk.
6. Gather information to assess fraud risks.
7. Develop overall audit plan and audit program
8. Timing and scheduling of the audit work
9. Work to be done by the client’s staff
10. Staffing requirement during the engagement
11. Target dates for completing major segments of the engagement
12. Any special problems to be resolved in the course of the engagement
13. Preliminary judgments about materiality level for the engagement.
1. Make client acceptance decisions and perform initial audit planning.

Initial Audit Planning

 Client acceptance and continuance
 Identify client’s reasons for audit
 Obtain an understanding with the client
 Develop overall audit strategy
2. Understanding of the Client’s Business and Industry

 Factors that have increased the importance of

understanding the client’s business and
industry:
1. Information technology
2. Global operations
3. Human capital
Understanding of the Client’s Business and Industry

Understand client’s business and industry

Industry and external environment

Business operations and processes

Management and governance

Objectives and strategies

Measurement and performance

Industry and External Environment
 Reasons for obtaining an understanding of the
client’s industry and external environment:
1. Risks associated with specific industries
2.Inherent risks common to all clients in
certain industries
3.Unique accounting requirements
Business Operations and Processes

 Factors the auditor should understand:

 Major sources of revenue
 Key customers and suppliers
 Sources of financing
 Information about related parties
Tour the Plant and Offices

 By viewing the physical facilities, the auditor

can asses physical safeguards over assets and
interpret accounting data related to assets.
Identify Related Parties
 A related party is defined as an affiliated

company, a principal owner of the client

company, or any other party with which the client
deals, where one of the parties can influence the
management or policies of the other.
Management and Governance
 Management establishes the strategies and
processes followed by the client’s business.
 Governance includes the client’s
organizational structure, as well as the
activities of the board of directors and the
audit committee.
 Corporate charter and bylaws

 Code of ethics

 Meeting minutes
Client Objectives and Strategies
 Strategies are approaches followed by the
entity to achieve organizational objectives.
 Auditors should understand client

 objectives.
Financial reporting reliability
Effectiveness and efficiency of operations
Compliance with laws and regulations
Measurement and Performance
 The client’s performance measurement system includes key
performance indicators.
 Examples:

 market share
 sales per employee
 unit sales growth
 web sit vistors
 same-store sales
 sales/square foot
 Performance measurement includes ratio analysis and

benchmarking against key competitors.

Assess Client Business Risk
 Client business risk is the risk that the client will fail
to achieve its objectives.
 What is the auditor’s primary concern?
 Material misstatements in the financial statements
due to client business risk.
 Client’s Business, Risk, and
Risk of Material Misstatement

Industry and external environment

Understand client’s
business and industry
Business operations and processes

Management and governance

Assess client business
risk
Objectives and strategies

Assess risk of material Measurement and performance

misstatements
Sarbanes-Oxley Act
 US law requires that management certify it
has designed disclosure controls and
procedures to ensure that material information
about business risks is made known to them.
 It also requires that management certify it has

informed the auditor and audit committee of

any significant deficiencies in internal control.
Preliminary Analytical Procedures
 Comparison of client ratios to industry or
competitor benchmarks provides an indication
of the company’s performance.
 Preliminary tests can reveal unusual changes

in ratios.
 Examples of Planning Analytical Procedures

Selected Ratios Client Industry

Short-term debt-paying ability:
Current ratio 3.86 5.20
Liquidity activity ratio:
Inventory turnover 3.36 5.20
Ability to meet long-term obligations:
Debt to equity 1.73 2.51
Profitability ratio:
Profit margin 0.05 0.07
Summary of the Parts of Auditing Planning

A major purpose is to gain an understanding

of the client’s business and industry.
Analytical Procedures

1. Required in the planning phase

2. Often done during the testing phase
3. Required during the completion phase
 Timing and Purposes of Analytical Procedures

(Required) (Required)
Planning Testing Completion
Purpose Phase Phase Phase
Understand client’s Primary
industry and business purpose
Assess going concern Secondary Secondary
purpose purpose
Indicate possible Primary Secondary Primary
misstatements
(attention directing) purpose purpose purpose
Reduce detailed tests Secondary Primary
purpose purpose
Five Types of Analytical
Procedures
Compare client data with:

1. Industry data
2. Similar prior-period data
3. Client-determined expected results
4. Auditor-determined expected results
5. Expected results using nonfinancial data.
 Compare Client and Industry Data

Client Industry
2009 2008 2009 2008
Inventory turnover 3.4 3.5 3.9 3.4
Gross margin 26.3% 26.4% 27.3% 26.2%
 Compare Client Data with Similar Prior Period Data

2009 2008
(000) % of (000) % of
Prelim. Net sales Prelim. Net sales

Net sales $143,086 100.0 $131,226 100.0

Cost of goods sold 103,241 72.1 94,876 72.3
Gross profit $ 39,845 27.9 $ 36,350 27.7
Selling expense 14,810 10.3 12,899 9.8
Administrative expense 17,665 12.4 16,757 12.8
Other 1,689 1.2 2,035 1.6
Earnings before taxes $ 5,681 4.0 $ 4,659 3.5
Income taxes 1,747 1.2 1,465 1.1
Net income $ 3,934 2.8 $ 3,194 2.4
Common Financial Ratios

 Short-term debt-paying ability

 Liquidity activity ratios

 Ability to meet long-term debt obligations

 Profitability ratios
Short-term Debt-paying Ability

(Cash + Marketable securities)

Cash ratio =
Current liabilities

(Cash + Marketable securities

Quick ratio = + Net accounts receivable)
Current liabilities

Current assets
Current ratio =
Current liabilities
 Liquidity Activity Ratios

Accounts receivable Net sales

=
turnover Average gross receivables
Days to collect 365 days
=
receivable Accounts receivable turnover
Inventory Cost of goods sold
=
turnover Average inventory
Days to sell 365 days
=
inventory Inventory turnover
Ability to Meet Long-term Debt Obligation

Total liabilities
Debt to equity =
Total equity

Times interest Operating income

=
earned Interest expense
 Profitability Ratios

Earnings Net income

=
per share Average common shares outstanding

Gross profit (Net sales – Cost of goods sold)

=
percent Net sales

Operating income
Profit margin =
Net sales
Profitability Ratios

Return on Income before taxes

=
assets Average total assets

Return on (Income before taxes

common = – Preferred dividends)
equity Average stockholders’ equity
Summary of Analytical Procedures
 They involve the computation of ratios and
other comparisons of recorded amounts to
auditor expectations.
 They are used in planning to understand the

client’s business and industry.

 They are used throughout the audit to identify

possible misstatements, reduce detailed tests,

and to assess going-concern issues.
Audit planning and its essentials

Accepting the Audit Engagement

 This is the first phase in the audit panning and it involves a

decision to accept or decline the opportunity to become the auditor

for the new client or to continue as an auditor for an existing
clients.
 The auditors should investigate the history of the prospective client,

including such matters as the identities and reputations of the

directors, officers and major shareholders, its financial statements.
 The auditor can find the information about the client by

communicating with predecessor auditors, making enquiries of

other third parties and consulting the client’s legal cause.
 Thus a decision to accept the audit engagement should not be taken

lightly as it has a bearing on the quality of the audit.

Audit planning and its essentials

The following steps should be considered in accepting

the audit engagement. These are:
1. Evaluate the integrity of management
2. Identify special circumstances and unusual risks
3. Competence to perform the audit
4. Evaluate Independence
5. Obtaining the Engagement
6. Obtaining an understanding of the clients’ Business
7. Developing an over all audit strategy
8. Designing Audit program
Audit planning and its essentials

Engagement letter: it is a formal letter sent by

the auditor to the client at the beginning of an
engagement. The letter normally includes the following
matters:
 Scope- a description of the services to be provided,
particularly whether there is to be an audit in accordance
with generally accepted auditing standards or a more
limited accounting services are to be provided, and
whether additional services are to be provided such as
preparation of the tax returns or tax planning.
Audit planning and its essentials

 Responsibility-an explanation of the relative responsibilities

of management and the auditor for assuring that financial
statements are with all material respects, in conformity with
generally accepted accounting principles and other matters
that often raise questions of responsibility such as fraud,
illegal acts, deficiencies in the design or operation of the
internal control structure and related party transactions.
 Procedural arrangements-this is a specification of the
schedules to be prepared by the client, the method and
frequency of billing the auditor’s fee and similar matters are
included.
5.2. Audit evidence

 The purpose of financial statement audit is the expression of an

opinion on the fairness of the financial statements.
 To have a basis for an opinion, the auditor has to gather
and evaluate evidence.
 The third standard of field work requires the auditor to

obtain sufficient and competent evidential matter.

 Audit evidence is any information used by the auditor to
determine whether the quantitative information being audited is
stated in accordance with the established criteria.
 The information varies widely in the extent to which it
persuades the auditor whether the financial statements are stated
in accordance with generally accepted accounting principles.
Audit evidence

 Audit evidence includes all the things that influence the

auditor’s judgment in evaluating whether the financial
statements are in conformity with GAAP.
 Audit evidence is any information or document that confirms
or rejects a premise (a statement or hypothesis).
 As an auditor, you, there fore need to obtain sufficient,
relevant and reliable evidence to satisfy your self that the
objectives of the individual audit have been met, and thereby
the overall audit opinion can be put forward.
 Thus most of the auditor’s work involves obtaining and
evaluating evidences.
Audit evidence

 What makes audit evidence competent and

sufficient?
 Competency of evidence is related to its quality
and reliability.
 Evidence is said to be competent if it is both valid
and relevant.
 The quality of audit evidence is affected by
1. the source of the audit evidence,
2. the strength of the client’s internal control and
3. the ability of the auditor to gather firsthand information.
Audit evidence

1. The source of the audit evidence: Evidence obtained

from independent sources outside the client is more
reliable than evidences obtained from the client.
2. The strength of the client’s internal control: The
quality and reliability of audit evidence increases if the
client has strong internal control
3. The ability of the auditor to gather first hand
information: Information obtained by auditors through
personal observation, computation or using other
techniques increases the reliability of audit evidence.
Audit evidence

The seven characteristics of competent evidence include:

1. Relevance--to the audit objective that the auditor is testing;
2. Independence of the provider--information received from outside the entity
is presumed to be more reliable than from inside the entity.
3. Effectiveness of the client's internal controls--evidence from a client whose
internal controls are effective is more trustworthy.
4. Auditor's direct knowledge--data or calculations prepared by someone
inside the organization will not be as reliable as data computed or discovered
by the auditor directly.
5. Qualifications of the individuals providing the information--reliability of
the information is enhanced if the person providing it is qualified to do so.
6. Degree of objectivity--objective evidence is more reliable than evidence that
is subjective.
7. Timeliness--data that are timely for the purpose intended are considered more
reliable.
Audit evidence

 Sufficiency of evidence relates to the quantity of evidence

auditors should obtain.
 Though the sufficiency audit evidence is determined by the
auditor’s professional judgment, factors such as
 competence,
 materiality and
 risk are the determinants of the sufficiency of audit evidence.
 In general, more evidences are needed for accounts that are
material to the financial statements than for accounts that are
immaterial. Similarly, more evidences are normally required for
accounts that are likely to be misstated than for accounts that are
likely to be correct. But still, the amount of evidence that is
considered sufficient to support the auditor’s opinion is a matter of
professional judgment.
Audit evidence

 The amount of evidence that is sufficient in a

specific situation varies inversely with the
appropriateness of the available evidence.
 Thus the more appropriate the evidence, the less
the amount of evidence that is needed to support
the auditor’s opinion.
 In short sufficiency and competency of audit
evidences are inversely related.
Audit evidence

One of the factors affecting the reliability of the audit

evidence is its source.
To clarify more, you may classify evidence as
follows:
 Evidence originated by the auditor,

 Evidence created by the third party and

 Evidence created by the management of the client.

Audit evidence

 Evidence created by the auditor: this type of

evidence is exceptionally reliable since there is
little risk of being manipulated by management.
 Analytical review procedures,
 physical inspection or observation and
 remeasurement of performance of calculations are
some of the reliable evidences that might obtained
by the auditors.
Audit evidence

 Evidences obtained from third parties: Evidences

obtained from third parties independent of the client
are more reliable than evidence produced by the client.
 Examples may include:
 confirmation letter obtained from the client’s customer,
 confirmation of bank balances,
 reports produced by specialists such as property valuations
and legal opinions,
 documents provided by the client which were issued by
third parties such as invoices.
Audit evidence

 Evidences originated from client’s management: this type of

evidence is less reliable than evidence obtained from outside
party.
 The degree of reliance to be placed on such evidence
depends on
 the reliability of the client,
 internal control and
 materiality of the item.
 Examples of such evidence includes the client’s accounting
records, supporting schedules, and the clients oral
explanations.
5.3. Types of audit evidence
 When conducting audits, auditors gather a
combination of many types of evidences.
 The auditor should consider whether the
conclusions drawn from different types of
evidences are consistent with one another.
 Audit evidence is a fundamental concept in
auditing and the major types of evidences that are
gathered during an audit are classified as follows:
Types of audit evidence
1. Physical evidence
2. Documentary evidence
3. Accounting Records
4. Written Representations
5. Mathematical evidence
6. Oral evidence
7. Analytical procedures.
Types of audit evidence
1.Physical evidence: physical evidence is obtained
from the physical examination or inspection of
tangible assets.
 This form of evidence is widely used by auditors in

the verification of tangible asset balances.

 Physical evidence is obtained from the actual

physical examination of the resources.

Types of audit evidence
 This type of evidence provides the auditor with direct
personal knowledge of the existence of an item.
 How ever, this type of evidence does not establish
the ownership or valuation of the asset.
 Physical evidence is also helpful in determining
quality of the asset.
 The auditor should supplement the evidence obtained
through physical examination by other types of
evidence to determine ownership and proper
valuation.
Types of audit evidence
2. Documentary evidence: This type of evidence
includes checks, invoices, contracts, minutes of the
meetings and others.
 Such documentation is contained in the client’s

files and is available to the auditor on request.

 The reliability of a document depends on

 the manner in which the document is created,

 the way it was obtained by the auditor and
 the nature of the document it self.
Types of audit evidence
 Documentary evidence may be created outside the
client organization or within it.
 Externally created documents may be sent directly
to the auditor by third party; or such documentation
may be held by the client.
 Externally created documents are viewed as the
highly reliable since the client does not have an
opportunity to alter the documents
Types of audit evidence
3. Accounting Records: An amount appearing in
financial statements may be verified by tracing it back
through ledger, journal, and source documents.
 When record is monitored by good internal control, it

provides reliable support for financial statements.

 When different persons maintain general ledger,

subsidiary ledgers and journal, reliability will be more.

 However, the auditor must be careful about alteration

or misstatements.
Types of audit evidence
4. Written Representations: A written representation is a signed
statement by responsible and knowledgeable individual about a
particular account, circumstances or events.
Written representations are a form of documentary evidence which
might originate from with in the client’s organization or external
sources.
 The auditor is required by GAAS to obtain certain written

representations and such representations are designed to document

management’s replies to inquiries made by the auditor during the
engagement.
 Management representations commonly presented in the form
of representation letter may reveal information not shown in
the accounting records such as existence of contingencies that
may require further investigation.
Types of audit evidence
 At the end of field work auditors obtain a written letter of
representations from the client, verifying oral representations
falling in to the following categories.
 All relevant records have been made available to the auditors,
financial statements are complete and prepared in conformity with
generally accepted accounting principles and all items requiring
disclosures have been disclosed properly.
 Auditors may also request written representations from out
side experts.
 An auditor is not expected to possess expertise of lawyers in
evaluating litigation pending against the client or geologist in
estimating the quantity of a mineral oil.
 When an auditor needs such evidence, they can use the work of a
specialist (lawyer or geologist) to obtain competent evidential matter.
Types of audit evidence
5. Mathematical evidence: This type of evidence is
results from the auditor’s computations or re-
computations.
Computations provide reliable evidence relevant to the
auditor objectives of clerical accuracy and valuation.
 Mathematical evidence may result from such routine
tasks as checking the footings of journals and ledgers,
or from complicated calculations pertaining to pension
plans and earnings per share data.
Types of audit evidence
6. Oral Evidence: Through out their examination the
auditors will ask a great many questions to the officers
and employees of the client’s organization.
 The answers to the auditors’ questions represent

another type of oral evidence. Generally oral evidence

is not sufficient in it self, but it may be useful in
disclosing situations that require investigation or in
corroborating other forms of evidence.
 Oral evidence serves the same audit objective as
written representation
Types of audit evidence
7. Analytical evidence: These are used to establish
reliability of information by analyzing relationships
among financial and other information.
 It involves determining an expected or desired

balance and determining the tolerance level.

 This type of audit evidence involves the use of

ratios and comparisons of the client data with

industry trends, general economic conditions, and
prior or expected company results.
Types of audit evidence
 Analytical evidence provides a basis for supporting an
inference on the fairness of a specific financial statement
item or relationship.
 Analytical evidence relates primarily to the existence,
completeness and valuation audit objectives.
 This type of evidence may help to understand client’s
strength and weakness in comparison to similar companies.
 However, auditors must be careful of comparability such as
size, accounting methods adopted and other business issues
5.4. Audit working papers and documentation

 Audit Working papers refer to the papers prepared by

the auditor for audit work as well as the documents,
statements, and recorded information obtained by the
auditor from his client and others connected with the
business.
 The documentation of audit evidence is provided
in working papers.
 Working papers are kept by the auditor’s of
 the procedures applied,
 the tests performed,
 the information obtained, and
 the pertinent conclusions reached in the audit.
Audit working papers

 Audit working papers consists of the auditing

procedures applied, evidence obtained, and
conclusions reached in the engagement.
 The audit documentation is the auditor's evidence
that the audit conforms to Generally Accepted
Audit Standards.
 Audit documentation is the property of the auditor
and is retained by the auditing firm at the
conclusion of the audit.
Audit working papers

 Working papers are the written private materials

which an auditor prepares for each audit.
 Working papers provide basic evidence of how the
audit was conducted and helps the auditor in
writing the report.
 Working papers are the connecting links between
the client’s accounting records and the auditor’s
report.
Audit working papers

Functions of working papers: Audit working papers assist auditors

in several ways
1. It helps to coordinate audit work.
2. It helps the seniors in supervising and receiving the work of
assistants.
3. It supports the audit report.
4. It helps the auditor to show his client the weakness of the internal
control system
5. It is a permanent record and is used as a defense in case of any
suit against him for negligence.
6. It helps for planning and conducting the next audit.
7. It serves as an evidence to show that the audit was made in
accordance with GAAS.
Audit working papers

Contents of working papers: Working papers normally

include:
1. The audit plan and programs
2. Copies of the documents received
3. Schedules of receivables and payables, fixed assets and
investments
4. Copies of any correspondences concerning the audit
work
5. Contract letter from the client
6. Particulars of depreciation
Audit working papers

7. Copies of the previous audit reports

8. Copies of the resolutions passed in the meetings of directors
and shareholders.
9. Certificates of management assertions.
10. Details of the questions made during the course of audit and
their explanations given
12. Understanding of the client’s internal control
13. Recommended journal entries necessary to correct the
accounts
14. Other necessary documents received for the conduct of the
audit work.
Audit working papers

Ownership of working papers: The audit working

papers being the matters documented and prepared
by the auditors are the property of the auditors, not
of the client.
 The client doesn’t have the right to demand access
to the auditor’s working papers. After the audit, the
working papers are retained by the auditors and the
custody of working papers rests with the auditor,
and the auditor is responsible for their safe keeping.
Audit working papers

 To conduct the satisfactory audit, the auditors must be

given unrestricted access to all information about the
client’s business. Much of this information is confidential
in nature. The information obtained and documented
through the working papers may be confidential and
hence working papers them selves are confidential in
nature.
 Hence auditors shall not disclose any confidential
information obtained in the course of a professional
engagement except with the consent of the client.
5.5. Materiality and Audit risk

 The term materiality is used both often and loosely in

accounting and auditing.
 The underlying concept is always essentially the same-
it is the criterion for distinguishing the trivial from
the important.
 It refers to the magnitude of an omission or
misstatement of accounting information that makes it
probable that the judgment of a reasonable person
relying on the information would have been changed or
influenced by the omission or misstatement.
Materiality and Audit risk

 Audit risk is the risk that the auditor may unknowingly fail
to appropriately modify his/her opinion on financial
statements that are materially misstated.
 This means that the auditor will fail to qualify an audit report
that he should have qualified
 There is always the risk that an auditor provides a wrong
audit opinion.
 This arises when there is a material error in the financial
statements, which was not corrected before the accounts
were published and to which the auditor did not refer in the
audit report.
Materiality and Audit risk

Audit risk is composed of inherent risk, control risk and

detection risk
 Inherent risk: refers to the possibility of a material
misstatement occurring in an account assuming that
there are no related internal controls.
 Inherent risk exists independently of the audit of
financial statements.
 Thus the auditor cannot change the actual level of
inherent risk.
 However, the auditor can change the assessed level of
inherent risk.
Materiality and Audit risk

Control risk: is the risk that a material misstatement

will not be prevented or detected on a timely basis
by the company’s internal control.
 Effective internal controls over an assertion reduce
control risk.
 Control risk can never be zero because internal controls
cannot provide complete assurance that all material
misstatements will be prevented or detected.
 Like inherent risk, the auditor cannot change the actual
level of control risk for an assertion.
Materiality and Audit risk


is the risk that the auditor’s procedures
Detection risk:
will lead them to conclude that a material misstatement
does not exist in an account balance, when in fact the
account is materially misstated.
 Detection risk is a function of the effectiveness of auditing procedures
and of their application by the auditor.
 Unlike inherent and control risk, the auditor can change the actual level
of detection risk by varying the nature, timing and extent of substantive
tests performed on assertion.
 Applying more effective audit procedures, use of larger samples,
adequate planning and adherence to quality control standards result in
lower levels of detection risk.
Materiality and Audit risk

 Note that while the detection risk related directly to the

effectiveness of the auditor’s procedures, inherent risk and
control risk are functions of the client and its environment.
 In planning the audit the auditors must assess the extent of
inherent risk and control risk for each material financial
statement account and then plan sufficient audit procedures
to reduce detection risk to the appropriate level.
 The lower the assessment of inherent and control risks, the
higher is the acceptable level of detection risk. Thus the
auditor controls the audit risk by adjusting detection risk
according to the assessed levels of the inherent and control
risks.
End of the Chapter