Chapter five: Audit Evidence

Introduction: As you might remember in previous chapters, 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, you have 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.

In this chapter you will study the nature of audit evidence, which will help you to distinguish between the concepts
of competency and sufficiency as they relate to auditing, the financial statement assertions provided by
management, the different types of audit evidence and their credibility and the use of audit working papers.

5.1-Nature of Audit Evidence

The third standard of field work requires an auditor to collect sufficient and competent evidence, which is the very
essence of auditing and forms the basis for issuing audit opinion. 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, therefore need to obtain sufficient, relevant and reliable evidence to satisfy yourself 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.

Q. 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 the source of the audit evidence, the strength of the
client’s internal control and the ability of the auditor to gather firsthand information. A brief discussion of each is
given below:

 The source of the audit evidence: Evidence obtained from independent sources outside the client is more
reliable than evidences obtained from the client.
 The strength of the client’s internal control: The quality and reliability of audit evidence increases if the
client has strong internal control

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  The ability of the auditor to gather firsthand information: Information obtained by auditors through
personal observation, computation or using other techniques increases the reliability of audit evidence.

Sufficiency of evidence relates to the quantity of evidence auditors should obtain. Though the sufficiency of
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. 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.

You might have realized that 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.

 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 re-
performance of calculations are some of the reliable evidences that might obtained by the auditors.
 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.
 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,

Assume the auditor gather the following documents to support his conclusions about the financial statements.
Classify each of the following documents as internal and external

1.Purchase requisitions
2. Bank statements
3.Remitance advices

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 4. Minutes of board of directors
5. General ledgers
6. Notes receivables
7. Receiving reports

5.2 Audit objectives and management assertions

Audit objectives:

The objective of the ordinary examination of financial statements by the auditor is the expression of an opinion
on the fairness of financial statements. The only reason why auditors accumulate evidence is to enable them to
reach conclusions about whether financial statements are fairly stated and issued as appropriate audit reports.
When the auditors conclude that the financial statements are unlikely to mislead a prudent user, the auditor gives
an audit opinion on their fair presentation and associate his/her name with the statements.

It is customary in the audit to identify audit objectives for the audit in general and for each account reported in
the financial statements. These objectives are derived from the assertions made by management that are
contained in the financial statements. The auditors’ assertions are closely related to management assertions. This
is not surprising, since the auditor’s primary responsibility is to determine whether management assertions about
financial statements are justified or correct.

Audit objectives are intended to provide a frame work to help the auditor accumulate sufficient and competent
evidence required by the third standard of field work and decide the proper evidence to accumulate given the
circumstances of the management. The objective remains the same from audit to audit, but the evidence varies,
depending on the circumstances.

The primary objective of audit evidence is to issue an opinion on the fairness of the presentations made in the
financial statements. To issue an opinion on the fairness of the financial statements the auditors need to gather
sufficient and competent evidence.

Management’s financial statement Assertions

Financial statements include both explicit and implicit management assertions. Management assertions are implied
or expressed representations by management about all the transactions and balances appearing in the financial

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statements. For example, consider that the current asset section of the balance sheet shows cash of Br. 50,000. In
reporting this item in the balance sheet, management makes the following two explicit assertions: (1) cash exists
and (2) the correct amount of cash is Br 50,000. Management also makes the following three implicit assertions: (1)
all cash that should be reported has been included, (2) all the reported cash is owned by the entity and (3) there are
no restrictions on the use cash. Therefore, assertions are the representations by management that are embodied in
financial statements. By presenting financial statements, management is stating either implicitly or explicitly certain
things about the company’s financial position and operations.

There are five broad categories of financial statement assertions. These are:

Existence or Occurrence: Assertions about existence or occurrence deal with whether assets and liabilities of
the entity exist at a given date, and whether recorded revenues and expense transactions have occurred during a
given accounting period. The auditor’s concern about this category of assertion relates primarily to the
overstatement of financial statement components through the inclusion of items that do not exist or the effects of
transactions that did not occur. But it does not extend to whether items that do exist and the effects of
transactions that did occur have been included at the correct amounts.

Completeness: Assertions about completeness deal with whether all transactions and accounts that would be
presented in the financial statements are so included. The auditor’s concern is about completeness assertions
relates primarily to the possible understatement of financial statement components through the omissions of
items that exist or omission of effects of transactions that occurred. But, the issue of correct amounts relates to
valuation or allocation assertion.

Valuation or allocation: Assertions about valuation and allocation are concerned with whether the asset,
liability, revenue and expense components have been included in the financial statements at appropriate
amounts. The reporting of financial statements component at an appropriate means that the amount has been
determined in conformity with GAAP and is free from of mathematical or clerical errors. Conformance with
GAAP includes appropriate application of the cost, matching, and consistency principles of accounting.

Rights and Obligations: Assertions about rights and obligations deal with whether assets are the rights of the
entity and liabilities are the obligations of the entity at a given date. The rights and obligation assertion pertain
only to the balance sheet components.

Presentation and disclosure: Assertion about presentation and disclosure deal with whether particular
components of the financial statements are properly classified, described and disclosed. This assertion involves
determining whether items are included in the correct accounts and accounts are properly displayed on the

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 financial statements. For example, assets must be properly separated in to current and fixed assets. The assertion
about disclosure involves that the balance sheet and income statement accounts and related information are
correctly set forth in the financial statements and properly described in the body and footnotes of the statements.

The following are specific audit objectives applied to the audit of accounts receivables. Describe the type of
assertion involved in each audit objective

1. There are no unrecorded receivables

2. Allowance for doubtful accounts has been provided for.
3. All accounts recorded are within the accounting period
4. All the accounts in the list have occurred during the normal business period

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 evidences that are gathered during an audit
are classified as follows:

 Physical evidence
 Documentary evidence
 Accounting Records
 Written Representations
 Mathematical evidence
 Oral evidence
 Evidence from analytical procedures.

Physical evidence: physical evidence is obtained from the physical examination or inspection of tangible assets.
This is widely used by auditors in the verification of tangible asset balances. Physical evidence is obtained from
the actual physical examination of the resources. This type of evidence provides the auditor with direct personal
knowledge of the existence of an item. However, 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.

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
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 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 itself.

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.

The reliability of internally created documents depends on the distribution or circulation of the documents.
Documents originated by the client such as canceled or paid checks that circulate outside the client organization
are considered more reliable than documents that remain entirely within the company. Examples of internally
created documents include sales invoices, shipping notices, purchase orders, and receiving reports. The
reliability of such types of documentary evidence depends on the quality of the internal control structure from
which the documents are generated.

Accounting Records: An amount appearing in financial statements may be verified by tracing it back through
ledger, journal, and source documents. When record keeping 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.

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 within 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. 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 outside 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.

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 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.

Oral Evidence: Throughout their examination, the auditors will ask 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 itself, 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.

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. 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 The Relationship between evidence and audit risk

There is strong relationship (high degree of correlation) between the audit risk and the type's evidence to be
collected to form an opinion regarding fairness of financial statements. While determining competence and
sufficiency of evidence, auditors must consider the audit risk i.e. the possibility of misstatement and their failure
to detect it and issuing inappropriate opinion. The audit risk includes inherent risk (possibility of material
misstatement assuming absence of internal control), and detection risk ( the risk that audit procedures may lead
to a conclusion that there is no material misstatement when in fact the accounts are materially misstated). While
planning the audit and determining the evidence requirement, the auditor must assess the degree of inherent and
control risks for each material item. Accordingly they should plan the audit procedures and quantity and quality
of evidence required to minimize detection risk by collection of enough competent evidence.

Conducting the complete audit i.e. examining each invoice, cheque or other documentary evidence is not
feasible. Therefore it is required to test adequacy and effectiveness of the methods and procedures adopted by
the company to control its accounting process so that the auditor can do with sample audit. In general the audit
risk can be minimized if the auditor is able to accumulate competent and sufficient evidence and the quality
(competency) and quantity (sufficiency) of evidence to be gathered depends on the internal control structure of
the client.

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 If the internal control system of the client is strong, then the control risk is low and the auditor may rely on such
strong internal control system and fail to design appropriate audit procedures. This in turn, may result in high
detection risk and vice versa.

5.5 Evidences provided by subsequent events

Evidence not available at the end of the period under audit sometimes becomes available before the auditors
finish their field work and write their audit report. The auditor’s opinion on the fairness of the financial
statements may be changed considerably by these subsequent events.

The term subsequent event refers to an event or transaction that occurs after the date of the balance sheet but
prior to the completion of the audit and issuance of the audit report.

Subsequent events may be classified in to two broad categories:

1)-Those providing additional evidence as to facts existing on or before the balance sheet date and
2)-Those involving facts coming in to existence after the balance sheet date

The first type of subsequent event provides additional evidence as to conditions that existed at the balance sheet
date and affects the estimates inherent in the process of preparing financial statements. These types of subsequent
events require that the financial statement amounts be adjusted to reflect the change in estimates resulting from the
additional evidence.

As an example, assume the large amount of receivable due from the client’s major customer was regarded as good
and collectible at year end, but during the course of the audit engagement the customer entered bankruptcy. The
bankruptcy of the customer shortly after the balance sheet date indicates that the client was simply in error in
believing the receivables to be good and collectible. Hence, the auditor should insist an increase in the year end
allowance for uncollectible accounts. Another good example is litigations pending against the client and shortly
settled after the balance sheet date. Such litigations are disclosed in notes to the financial statements and when such
litigations are settled it becomes actual liability and should be reported on the balance sheet date.

The second type of subsequent event involves conditions coming into existence after the balance sheet date. These
types of subsequent events don’t require adjustment to the financial statements, but they should be disclosed to the
financial statements.

For example, if the client sustains an uninsured fire loss destroying most of its plant assets, shortly after the balance
sheet date, but during the course of audit engagement, the carrying value of plant assets should not be reduced
because these assets were correct at the end of the year. However, the event should be disclosed to the financial
statements as foot note.

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Although these events may be significant in the future operations of the company and of interest to many who read
the audited financial statements, none of these occurrences has any bearing on the results of the year under audit,
and their bearing on future results is not easily determinable.

In deciding whether a particular subsequent event should result in adjustment to the financial statements or footnote
disclosures, the auditor should carefully consider when the underlying conditions came in to existence. Closely
related to subsequent event is subsequent period. The subsequent period is the period of time between the balance
sheet date and the last day of field work. During this period the auditors should determine that proper cutoffs cash
receipts and disbursements and sales and purchases have been made and should examine data to aid in the valuation
of assets and liabilities as of the balance sheet date.

In addition, the auditors should:

 Review the latest available interim financial statements and minutes of the directors, stockholders and
appropriate committees’ meetings.
 Inquire about matters dealt with at meetings for which minutes are not available.
 Inquire appropriate client officials as to loss contingencies, change in capital stocks, debt or working capital,
change in the current status of items estimated in the financial statements under audit or any unusual
adjustments made subsequent to the balance sheet date
 Obtain a letter from the client’s attorney describing as of the last day of field work, pending litigation,
unasserted claims, or other loss contingencies.
 Obtain a letter of representation from the client concerning subsequent events. This letter should be dated as
of the last day of the field work.
Generally the auditor’s responsibility for performing audit procedures to gather evidence as to subsequent
events extends only through the last day of field work. However, even after completing normal audit procedures,
the auditors have the responsibility to evaluate subsequent that come in to their attention. Suppose, for example,
that the auditors completed their field work for the December 31 audit on February 3 and thereafter began
writing their report. On February 12, before completing their report, the auditors were informed by the client
that the lawsuit, which had been footnoted as a loss contingency in the December 31 financial statements, had
been settled on February 11 by a substantial payment by the client. In such cases the auditors should have to
insist that the loss contingency be changed to a real liability in the December 31 balance sheet and that the
footnote be revised to show the settlement of the lawsuit subsequent to the balance sheet date.

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 5.6 Audit working papers

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 auditors of
the procedures applied, the tests performed, the information obtained, and the pertinent conclusions reached in
the audit. Working papers are the written private materials which an auditor prepares for each audit. It describes
the accounting information which an auditor received from the client, the method of examination, conclusions
and the reasons thereof and the financial statements.

Working papers provide basic evidence of audit conducted in accordance with the standards audit practices 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.

Functions of working papers: Audit working papers assist auditors in several ways

1-It provides a means of the assigning and coordinating 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 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.
Contents of working papers: Working papers normally include:

 the audit plan and programs

 -Copies of the documents received
 Schedules of receivables and payables, fixed assets and investments
 Copies of any correspondences concerning the audit work
 Contract letter from the client
 Particulars of depreciation
 Copies of the previous audit reports
 Copies of the resolutions passed in the meetings of directors and shareholders.
 Certificates of management assertions.
 Details of the questions made during the course of audit and their explanations given
 Understanding of the client’s internal control

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  Recommended journal entries necessary to correct the accounts
 Other necessary documents received for the conduct of the audit work.

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.

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.

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