Chapter-Five: Audit Responsibility, Objectives, Evidence

and Recording the Audit

5.1 Audit Responsibility
The auditor should assess the risk that errors and irregularities may cause the financial statements
to contain a material misstatement. Based on that assessment, the auditor should design the audit
to provide reasonable assurance of detecting errors and irregularities that are material to the
financial statements.
The auditor's assessment of the risk of material misstatement of the financial statements requires
the auditor to understand the characteristics of errors & irregularities and the complex interaction
of those characteristics. Based on that understanding, the auditor designs and performs
appropriate audit procedures and evaluates the results.
Because of the characteristics of irregularities, particularly those involving forgery and collusion,
a properly designed and executed audit may not detect a material irregularity. For example,
generally accepted auditing standards do not require that an auditor authenticate documents, nor
is the auditor trained to do so. Also, audit procedures that are effective for detecting a
misstatement that is unintentional may be ineffective for a misstatement that is intentional and is
concealed through collusion between client personnel and third parties or among management or
employees of the client.
The auditor should exercise (a) due care in planning, performing, and evaluating the results of
audit procedures, and (b) the proper degree of professional skepticism to achieve reasonable
assurance that material errors or irregularities will be detected. Since the auditor's opinion on the
financial statements is based on the concept of reasonable assurance, the auditor is not an insurer
and his report does not constitute a guarantee. Therefore, the subsequent discovery that a
material misstatement exists in the financial statements does not, in and of itself, evidence
inadequate planning, performance, or judgment on the part of the auditor.

5.2 Management Assertions

During audits, auditors use specific characteristics to test whether financial records and
disclosures are correct and appropriate. Such characteristics are assertions. If the
company meets assertions on paper, financial statements are recorded correctly.

What are Management Assertions?

Management assertions, or in other words, financial statement assertions, are claims made
by the company’s management related to specific business aspects. Such claims include
the measurement, recognition, disclosure, and presentation of financial information about
the company’s statements.
The auditor must prove the management prepared assertions which can be confirmed.
During an internal audit, auditors pay attention to any detail to detect fraud, so it’s
critical to prepare financial statement assertions correctly to pass the auditors’ test.
Typically, financial statement assertions fall into the following three categories:

 transaction-level assertions;
 account balance assertions;
 Presentation & disclosure assertions.
Assertions have major differences, and accountants need to ensure everything is prepared
correctly.

Assertions and Auditing

The IFRS (International Financial Reporting Standards) discloses accounting standards

accepted by the IASB (International Accounting Standards Board). The IFRS offers
generally accepted standards for accounting rules that are transparent, comparable, and
consistent.

The IFRS provides companies with the ISA315 standard which includes categories of
assertions used to check financial records. Companies have to meet such standards to pass
audits. Similarly, auditors use these standards to test the company’s financial statements.
Let’s check these categories in detail.

1. Transaction-Level Assertions

These are assertions related to financial transactions, business events, correct accounts in
the general ledger, etc. The accountant must record these assertions without errors and
during the correct reporting period.
Accounting recognizes these five items as assertions related to transactions:

 Accuracy: An accountant must record full amounts of transactions without making

any errors.
 Completeness: The accountant must correctly add all business events related to the
company.
 Classification: The accountant must add all transactions to the general ledger.
Transactions must contain full accounts.
 Cutoff: The accountant adds all transactions within the appropriate recording period.
 Occurrence: The Company must show evidence that all business transactions occurred
in reality.
It’s just the first type of management assertion, but accountants must make sure they
record transactions according to all requirements.

2. Account Balance Assertions

These four items are categorized as assertions related to the ending balances in accounts:

 Existence: All account balances exist for assets, liabilities, and the shareholder’s
equity.
 Completeness: All asset, liability, and equity balances that an accountant reports in
full volumes.
 Valuation: The Company recorded all asset, liability, and equity balances at their
correct valuations.
 Rights and obligations: The accountant records the entity with the rights to the assets
it owns. The entity is obligated according to the liabilities a company reports.

These mentioned four items are related to the balance sheet.

3. Presentation & Disclosure Assertions

These five items are categorized as assertions related to the data presented within the
financial statements and all accompanying disclosures:

 Completeness: The accountant discloses all transactions that the company must
disclose.
 Accuracy: The Company proves that all data it discloses is in the correct amounts. It
should also show proper values.
 Occurrence: The Company should disclose transactions that have occurred.
 Rights and obligations: The Company discloses rights and obligations that indeed
relate to the entity it reports.
 Understandability: The Company must prove that information it includes in the
financial statement is presented correctly and understandably.

Given these three types of management assertions have duplications; one might assume
they are identical. However, each assertion has its goal and aims at different aspects of
the financial statement.

The first management assertion is related to the income statement, the second type is to
the balance sheet, and the third is to the accompanying disclosures. That’s why
companies’ management must pay attention when preparing management assertions.
5.3 Audit Objectives
General transaction-related audit objectives are essentially the same as management assertions, but
they are expanded somewhat to help the auditor decide which audit evidence is necessary to satisfy
the management assertions. Accuracy and posting and summarization are a subset of the
accuracy assertion. Specific transaction-related audit objectives are determined by the auditor
for each general transaction-related audit objective. These are done for each transaction cycle
to help the auditor determine the specific amount of evidence needed for that cycle to satisfy the
general transaction-related audit objectives.

Examples for specific audit objectives with related management assertion are presented as
follows:

SPECIFIC BALANCE-
RELATED AUDIT MANAGEMENT
OBJECTIVE ASSERTION COMMENTS

a. There are no Completeness Unrecorded transactions or amounts deal with

unrecorded receivables. the completeness objective.

b. Receivables that have Valuation or This is part of the realizable value objective
become uncollectible allocation and the valuation or allocation assertion.
have been written off. There may also be some argument that this is
part of the existence objective and assertion.
Accounts that are uncollectible are no longer
valid assets.

c. All accounts on the list Valuation or Accounts that are not expected to be collected
are expected to be allocation within a year should be classified as long-
collected within one term receivables. It is therefore included as
year. part of the classification objective and
consequently under the valuation or
allocation assertion.
 d. The total of the amounts Valuation This is part of the detail tie-in objective and is
on the accounts receivable part of the valuation or allocation assertion.
listing agrees with the
general ledger balance for
accounts receivable. The
total of the amounts on the
accounts receivable listing
agrees with the general
ledger balance for
accounts receivable.

g. All accounts on the list Valuation Concerns the classification of accounts

arose from the normal receivable and is therefore a part of the
course of business and classification objective and the valuation or
are not due from related allocation assertion.
parties.

h. Sales cutoff at year- end Valuation Cutoff is a part of the cutoff objective and
is proper. therefore part of the valuation or allocation
assertion.

MANAGEMENT
SPECIFIC TRANSACTION-RELATED AUDIT OBJECTIVE ASSERTION
a. Recorded cash disbursement transactions are for the amount of goods or Accuracy
services received and are correctly recorded.
b. Cash disbursement transactions are properly included in the accounts Accuracy
payable master file and are correctly summarized.
c. Recorded cash disbursements are for goods and services actually received. Occurrence
d. Cash disbursement transactions are properly classified. Classification
e. Existing cash disbursement transactions are recorded. Completeness
f. Cash disbursement transactions are recorded on the correct dates. Cutoff

SPECIFIC PRESENTATION AND MANAGEMENT

DISCLOSURE-RELATED AUDIT OBJECTIVE ASSERTION

a. All required disclosures about fixed assets have been made. Completeness

b. Footnote disclosures related to fixed assets are clear and understandable. Classification and
understandability
c. Methods and useful lives disclosed for each category of fixed assets are accurate. Accuracy and valuation

d. Disclosed fixed asset dispositions have occurred. Occurrence and rights

and obligations

5.4 Audit Evidence Decisions

Major decision of an auditor involves determining the appropriate type & 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:
Which audit procedure to use (Audit Procedure?)
Which sample size to select for a given procedure (Sample Size?)
Which items to select from population (Items?)
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 issued 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.

5.4.1 Nature of Evidential Matter

Evidential matter is any information that supports or disproves 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 third fieldwork
standard states that sufficient competent evidential matter should be obtained to afford a
reasonable basis for an opinion regarding the financial statements under audit. It is unlikely to
say that the auditor will be completely convinced that the opinion is correct because of the nature
of audit evidence and cost limitations. However, he must be persuaded that his/her opinion is
correct with high level of assurance.
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. It isn't improved by
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.

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 within.
Effectiveness of client's internal control: - Strong internal control systems produce more
reliable evidence than weaker ones.
Auditors’ direct knowledge: - Information obtained directly by the auditor through physical
examination, observation and computation are more competent.
Qualifications of individuals providing information:- The person who provides information
must be qualified to do so. This affects the competence of the evidence.
Degree of objectivity:- Objective evidences are more reliable than subjective. Examples of
objective evidence are physical counts; confirmation from banks on cash balances, adding
subsidiaries to check against related general ledgers etc.
Timeliness:- This refers either to when evidence is accumulated or the period covered by the
audit. For balance sheet items it is good if evidence is collected near balance sheet dates. For
income statement it is timely if the sample is taken from the entire period under audit rather than
only from part of the period.

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
- The strength of client's internal control
In addition to sample size, individual items may affect sufficiency. For example,
Items with larger dollar value
Items susceptible to misstatement
Items representative of the population
To sum up, the persuasiveness of evidence is judged by the combined effect of competency and
sufficiency.
In answering the question of persuasiveness, cost consideration must also exist. The objective is
to obtain a sufficient amount of competent evidence at the lowest possible cost.

5.4.2 TYPES of AUDIT EVIDENCES

The major types of audit evidences gathered by the auditor during audit are the following:
1. Physical evidence: Actual physical examination or observation provides the best evidence of
the existence of certain assets. The existence of the property may be established through
physical examination. For example, the existence of plant assets, inventory, cash etc can be
verified by the physical examination. It might seem that physical examination of an asset
would be conclusive verification of all assertions relating to that asset. It may not be always
true. Physical verification gives evidence of the existence of the asset to the auditor.
2. Documentary evidence: Another types of evidence relied upon by the auditor is the
documents. The worth of the documentary evidence depends on whether the documents are
created within the company (sales invoices) or it came from outside the company (vendors
invoice). Sometimes the documents created within the organization are sent outside for
endorsement and processing and these documents are regarded as very reliable evidence. In
accepting the reliability of the documentary evidence, the auditor should consider whether
the document is of a type that could easily be forged or created in its entirety by a dishonest
employee. The documentary evidence is classified into three categories and they are
a. Documents created outside the organization and transmitted directly to the auditor- the
most reliable documentary evidence consists of documents created by independent
parties outside the organization and transmitted directly to the auditors without passing
through the client’s hands. For example, the verification of accounts receivable
b. Documents created outside the organization and held by the organization-many of the
externally created documents referred to by the auditors will be in the possession of
 organization. For example, bank statements, vendor’s invoices and statements, property
tax bills notes receivables etc.
c. Documents created and held within the organization- most documents created within
the organization represent a lower quality of evidence because they circulate only
within the company and do not receive critical review by an outsider. For example, the
sales invoices, shipping notices, purchase orders etc. The degree of reliance to be
placed on documents created and used only within the organization depends on the
effectiveness of the internal control. If the accounting procedures are so designed that
another person must critically review a document prepared by one person and if all
documents are serially numbered and all numbers in the series accounted for, these
documents may represent reasonably good evidence. Adequate internal control will also
provide for extensive segregation of duties so that no one handles a transaction from
beginning to end.
3. Accounting records as evidence: the dependability of ledgers and journals as evidence is
indicated by the extent of internal control covering their preparation. An auditor will attempt
to verify an amount in the financial statements by tracing it back through the accounting
records. They will ordinarily carry this process through the ledgers to the journals and vouch
the item to such basic documentary evidence. To some extent, the ledger and journals
constitute worthwhile evidence in themselves to the auditors

4. Evidence from the analytical procedures: analytical procedures involve evaluations of the
financial statements by a study of relationships among financial and nonfinancial data. The
process of analytical procedures consists of four steps
a. Develop an expectation of an account balance
b. Determine the amount of difference from the expectation that can be accepted without
investigation
c. Compare the account balances with the expected account balance
d. Investigate the significant deviations from the expected account balance

Techniques used in performing analytical procedures range from complex models involving
many relationships and data from many years. For example, comparison of revenue and expense
amounts for the current year to those of the previous years and to the industries average.

5. Evidence from computations: to prove the arithmetical accuracy of the client’s records, the
auditor make computations independently as another form of audit evidence. Computations
verify the mathematical processes and used to prove the calculation of the client.
6. 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. If the auditor feels that
 the expert is not an independent person, he may perform additional procedures or engage
another specialist.
7. 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, the reasons underlying an unusual accounting procedures,
the probabilities of collecting a long past due accounting receivables etc. The answers the
auditor receives to the questions constitute another type of evidence.
8. 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. These letters are dated as the last day of the fieldwork and usually signed by the
chief executive officer and chief finance officer. Most of the representations fall into the
following categories
1. All accounting records, financial data and minutes of the directors meetings have
been made available to the auditors
2. The financial statements are complete and prepared in conformity with the generally
accepted accounting principles
3. All items requiring disclosure have been properly disclosed

5.4.3 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. Thus, the more sufficient and
competent the audit evidence obtained, the less will be the audit risk.
For each financial statement account, audit risk consists of the possibility that:
(1) A material misstatement in an assertion about the account has occurred, and
(2) The auditors do not detect the misstatement.

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.
Inherent risk also varies by the nature of the account. For instance, if we consider two balance
sheet accounts-cash accounts and building account and if we assume that the balance of cash
account is only one tenth that of building account, this does not mean that the inherent risk
associated with cash account will also be one-tenth as much that of the building accounts.
Rather, the inherent risk associated with the cash account may be much more than one-tenth of
the inherent risk associated with the building accounts. This is due to susceptible nature of cash
account to error or theft than are building accounts.
Thus, auditors may spend much more time in auditing cash accounts than the assumed
proportion of their inherent risk.
Inherent risk also varies with the assertion about a particular account. As an example, valuation
of assets is often a more difficult assertion to audit than is existence of the assets.
The auditor use their knowledge of the clients industry and the nature of its operations, including
information obtained in prior years audits to assess inherent risk for the financial statement
assertions

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.

To assess control risk, auditors consider the client’s control that affects the reliability of financial
reporting. Well designed controls that operate effectively increase the reliability of accounting
data.
To obtain an understanding of the client’s internal control and to determine whether it is
designed and operating effectively, the auditors use a combination of inquiry, inspection,
observation, and performance of audit procedures.
If the auditors find that the client has designed effective internal control for a particular account
and that the prescribed practice operate effectively in day-to-day operation, they will assess
control risk for the related assertions to be low, and there by accept a higher level of detection
risk, i.e. the more effective internal control is, the lesser will be the control risk and the higher
will be the detection risk. That is because, effective internal control leads to the use of low
substantive testing procedure by auditors which may in turn lead to high detection risk

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.

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. 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 avoided
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. Regardless of how much evidence the auditors gather, they cannot change these
risks. Therefore, evidence gathered by the auditors is used to assess the levels of inherent and
control risks.

Detection risk on the other hand, is a function of the effectiveness of the audit procedures
performed. If the auditors wish to reduce the level of detection risk, they need to obtain
additional competent evidence. As a result, detection risk is the only risk that is completely a
function of the sufficiency of the procedures performed by the auditors.

5.5 Audit Documentation/ audit working papers /

Audit documentation/audit working paper/ is the record of procedures performed, evidence
obtained, and conclusions reached as part of an audit.
The proper preparation of audit documentation is critical for several reasons, including the
following:

 It can be used as a defense if the auditor is ever accused of negligence.

 It is easier for a reviewer to examine.
 It represents a better level of quality control over an audit.
 It shows auditors in later years how the audit was conducted.
 It can be used as a training tool for junior auditors.
The types of audit documentation that should be assembled include the following: Analyses
conducted, Audit plans, Checklists, Confirmation letters (can apply to all types of
confirmations, including bank, loan, and consigned inventory confirmations),
Documentation of physical counts observed (can apply to both inventory and fixed asset
counts), Memoranda and correspondence regarding issues found, Records of oral interviews,
Representation letters, and Summaries of significant findings.