CHAPTER 14 RISK RESPONSE – PART II

IMPLEMENTING THE DESIGNED RISK RESPONSE AND OBTAINING AUDIT EVIDENCE

This phase involves the implementation of the designed risk response and accumulatio of evidence
about internal control operating effectiveness, accounts, disclosures and assertions.

PSA 500, “Audit Evidence” explains what constitutes audit evidence in an audit of financial statements,
and deals with the auditor’s responsibility to design and perform audit evidence to be able to draw
procedures to obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on
which to base the auditor’s opinion.

NATURE AND SIGNIFICANCE OF AUDIT EVIDENCE

Audit evidence is all the information used by the auditor in arriving at the conclusions on which
the audit opinion is based, and includes both information contained in the accounting records
underlying the financial statements and other information.

The auditor shall perform audit procedures that are appropriate in the circumstances for the
purpose of obtaining sufficient appropriate audit evidence.

Appropriateness (of audit evidence) is the measure of the quality of audit evidence; that is, its relevance
and its reliability in providing support for the conclusions on which the auditor’s opinion is based.

Sufficiency (of audit evidence) is the measure of the quantity of audit evidence. The quantity of the
audit evidence needed is affected by the auditor’s assessment of the risk of material misstatement and
also by the quality of such audit evidence.

The ultimate goal of an audit is to express an opinion as to whether the financial statements are
presented fairly in accordance with financial reporting standards. When management prepares financial
statements which purport to be in conformity with financial reporting standards, certain assertions
(implicit or explicit) are made.

WHAT CONSTITUTES AUDIT EVIDENCE

Accounting records general include records of initial entries and supporting records, such as
checks and records of electronic fund transfer; invoices; contracts; the general and subsidiary ledgers,
journal entries and other adjustments to the financial statements that are not reflected in formal journal
entries; and records such as work sheets and spreadsheets supporting cost allocations; computations,
reconciliations and disclosures. The entries in the accounting records are often initiated, recorded,
processed, and reported in electronic form.
SUFFICIENT APPROPRIATE AUDIT EVIDENCE

The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable
conclusions on which to base the audit opinion.

Sufficiency and appropriateness are interrelated and apply to audit evidence obtained from both
tests of control and substantive procedures. Sufficiency is the measure of quantity of audit evidence;
appropriateness is the measure of the quality of audit evidence and its relevance to a particular
assertion and its reliability.

The auditor’s judgement as to what is sufficient appropriate audit evidence is influenced by such factors
as the:

o Auditor’s assessment of the nature and level of inherent risk at both the financial statement
level and account balance or class of transactions level.
o Nature of accounting and internal control systems and the assessment of control risk.
o Materiality of the item being examined.
o Experience gained during previous audits.

INTERRELATIONSHIP BETWEEN RISK, APPROPRIATENESS AND SUFFIECIENCY OF AUDIT EVIDENCE

 • Audit evidence is more reliable when it is obtained from independent sources outside
the entity.
• Audit evidence that is generated internally is more reliable when the related controls
imposed by the entity are effective.
• Audit evidence obtained directly from auditor (for example, observation of the
application of control) is more reliable than audit evidence obtained indirectly or by
inference (for example, inquiry about the application of a control)
• Audit evidence is more reliable when it is exists in documentary form, whether paper,
electronic, or other medium (for ex. A contemporaneously written record of a meeting
is more reliable than a subsequent oral presentation of the matters discussed)
• Audit evidence provided by original documents is more liable than audit evidence
provided by photocopies or facsimiles.

COMPETENCE OR APPROPRIATENESS OF EVIDNCE

The competence or appropriateness of evidence refers to its trustworthiness or believability. The

factors that determine that competence of evidence are:

1. Relevance of the evidence to the particular assertion being tested

2. Objectivity of the evidence
3. Qualifications of the provider of the evidence
4. Timeliness of the evidence

The hierarchy starts with the strongest form of evidence and proceeds to the weakest.

1. An auditor’s direct, personal knowledge, obtained through physical observation and his or her
own mathematical computations is generally considered the most competence evidence.
2. Documentary evidence obtained directly from independent external sources (external evidence)
is considered competent.
3. Documentary evidence has originated outside the client’s data processing system but which has
been received and processed by the client (external-internal evidence) is generally considered
competent. However, circumstances of internal control quality are important.
4. Internal evidence consisting of documents that are produced, circulated, and finally stored
within client’s information system is generally considered low in competence.
** however, internal evidence is used extensively when it is produced under satisfactory
conditions or internal control.
5. Verbal and written representations given by the client’s officers, directors, owners, and
employees are generally considered the least competent evidence.
 SUFFICIENCY OF EVIDENCE

Sufficiency of audit evidence refers to the amount of quality of evidence gathered. The concept of
sufficiency recognizes that the accumulation of evidence should be persuasive rather than
convincing.

This concept is consistent with the idea that the auditor is not free to collect unlimited amounts of
evidence since he must work within economic limits. Cost cannot, however the sole basis for the
quantity or quality of audit procedures. Auditor use professional judgment to determine the extent of
test necessary to obtain sufficient evidence. In exercising their professional judgment, auditors consider
both the (1) materiality (e.g., cash due to its liquidity, may have a higher relative risk than certain
property, plan and equipment do).

PROCEDURES FOR OBTAINING AUDIT EVIDENCE

The auditor obtains audit evidence by one or more following procedures:

1. Inspection,
2. Observation,
3. Inquiry and Information,
4. Recalculation,
5. Reperformance and,
6. Analytical procedures.

Inspection of Record or Documents

Inspection involves the examination of records,, documents, or tangible assets, Record and documents
are inspected to provide audit evidence of varying degrees of reliability depending on their nature and
source and the effectiveness of internal control over their processing.

Inspection of tangible Assets

Inspection or physical examination of tangible assets provides reliable audit evidence with respect to
their existence but not necessarily as to their ownership or value.

This applicable in the verification of inventory, cash, fixed tangible assets, securities and notes
receivable

Confirmation

Confirmation, which is a specific type of inquiry, is the process of obtaining a representation of

information or of an existing condition directly from a third party.

An external confirmation describes the receipt of a written response from an independent third party, in
a paper from, or by electronic or other medium, verifying the accuracy of information that was
requested by the auditor. Other example of situations where external confirmations may be used
included the following:
 • Bank balance and other information from bankers.
• Accounts receivable balances.
• Inventories held by third parties and bonded warehouses for processing or on consignment.
• Property titles deeds held by lawyers or financiers for safe custody or as security.

In the confirmation of account balances, the auditor may use the (a) positive or (b) negative form of
confirmation.

A positive external confirmation request asks the respondent to reply to the auditor in all cases either
by indicator the respondent’s agreement with the given information, or by asking the respondent to fill
in information.

A Negative external confirmation request asks the respondent to reply only in the event of
disagreement with the information provided in the request.

Negative confirmation requests may be used to reduce audit risk to an acceptable level when:

(a) The assessed level of inherent and control risk is low;

(b) A large number of a small balances is involved;
(c) A substantial number of errors is not expected; and
(d) The auditor has no reason to believe that respondents will disregard these request

Inquiry

Inquiry involve seeking information both financial and nonfinancial of knowledgeable persons inside or
outside the entity. Inquiries may include formal written inquiries address to third parties to informal
oral inquiries addressed to persons inside the entity.

Written Representations

PSA 580, “Written Representation” provides that audit evidence is all the information used by the
auditor in arriving at the conclusion on which the audit opinion is based. Written representations are
necessary information that the auditors requires in connection in the audit of the entity’s financial
statements. Accordingly, similar to responses to inquiries, written representations an audit evidence.

Representations letters may be obtained for general representations. As described in PSA 580 (figure14-
5). It may also be obtained for limited representations. Such as;

a. Accounts receivable (figure 14-6)

b. Inventories (Figure 14-7)
c. Liabilities (figure 14-8)
Observation

Observation consists of looking oat a process or procedure being performed by others.

Observation provides audit evidence about the performance of a process or procedures, but is limited to
the point in time at which the observation take place and by the fact that the act of being observed may
effect how the process or procedure is performed.

Recalculation

Recalculation consists of checking the mathematical accuracy of source documents and accounting
records or of performing independent calculations

Reperformance

Reperformance is the auditor’s independent execution of procedure or controls that were originally
performed as part of the entity’s internal control, either manually or through the use of CAATs, for
example, reperforming the aging of accounts receivable.

Analytical Procedures

Analytical procedures consist of evaluations of financial information made by a study of plausible

relationships among both financial and nonfinancial data.

RELATIONSHIP OF TYPES OF EVIDENCE TO AUDIT ABJECTIVES

Since the auditors evaluation of the fairness of the presentation of the financial statement
heavenly depends upon the evidence of their fairness, care must be taken to obtained as much
evidence as is needed to make a proper evaluation.

It is also important to have an understanding of the relationship of the type of evidence to audit
objectives.

The audit objective can be accomplished with the use of the seven types of evidence. For a give
account and related accounts in a web, the auditor select evidence to accomplished all the objectives at
minimum cost.

EVIDENCE ABOUT ACCOUNTING ESTIMATE

Careful consideration must be given by the auditor on financial statement accounts that are
effected by estimates made by management (often referred to as accounting estimate). Particularly
those for which a wide range of accounting methods are considered acceptable.

The auditor should obtain sufficient appropriate auding evidence regarding accounting estimate.
“Accounting estimate” means an approximation of the amount of an items in the absence of a precise
means of measurements. Examples are:

• Allowances to reduce inventory and account receivable to their estimated realizable value.
 • Provision to allocate the cost of fix assets over their estimated useful lives.
• Accrued revenue.
•

NATURE OF ACCOUNTING ESTIMATE

The determination of an accounting estimate may be simple or complex depending upon the nature of
the item.

• In complex estimates, there may be high degree of special knowledge and judgement required.

In many cases, accounting estimates are made by using formula based on experience, such as the
use of standard rates for depreciating each category of fixed assets or a standard percentage of sales
revenue for computing a warranty provision.

Ex. Reassessing the remaining useful lives of assets or by comparing actual results with the
estimates and adjusting the formula when necessary.

Audit procedures

The auditor should obtain sufficient appropriate audit evidence as to whether an accounting estimates is
reasonable in the circumstances and, when required, is appropriately disclosed.

The auditor should adopt one or a combination of the ff. approaches in the audit of an accounting
estimates:

(1) Review and test the process used by management to develop the estimate;
(2) Use an independent estimate for comparison with what prepared by management; or
(3) review subsequent events which confirm the estimate made

Reviewing and testing the process

The steps ordinarily involved in reviewing and testing of the process used by management are:

(a) evaluation of data and consideration of assumptions on which the estimate is based;
(b) testing of the calculations involved in the estimate;
(c) comparison, when possible, of estimates made for prior periods with actual results of those
periods; and
(d) consideration of management’s approval procedures

Evaluation of results of audit procedures

the auditor should make a final assessment of the reasonableness of the estimate based on the auditor’s
knowledge of the business and whether the estimate is consistent with other audit evidence obtained
during the audit.
EVIDENCE FOR RELATED PARTY TRANSACTIONS

How should auditors react if a corporation buys a parcel of real estate from-one of its executives
officers at an obviously excessive price?

The term related parties refers 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 won separate interests.

A related party transaction is any transaction between the company and these parties. Since
transactions with related parties are not conducted at arm’s length, the auditors should be aware that
the economic substance of these transactions may differ from their form.

A list of all known related parties should be prepared at the beginning of the audit so that the
audit staff may be alert for related party transactions throughout the engagement.

The primary concern of the auditors is that material related party transactions are adequately
disclosed in the clients financial statements or the related notes. Disclosure of related party transactions
should include: the nature of the relationship; a description of the transactions, including peso amounts;
and amounts due to and from related parties, together with terms and manner of settlement.