Chapter 7Chapter 7

Direct Tests of Account Direct Tests of Account BalancesBalances

Overview of Evidence for Directly Testing Financial

Statement ItemsEvidence-gathering is the core of the audit.

Auditing is a process of gathering evidence to test assertions.

Why do we need audit evidence?

•Minimize audit risk.

•Support the opinion.

EvidenceThe Second Standard of Fieldwork: The Second Standard of Fieldwork:

Sufficient, competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit.

Assertions

•Existence or occurrence

•Completeness

•Rights and obligations

•Valuation or allocation

•Presentation and disclosure

Approach to Gathering Evidence

Factors to consider:

•management integrity

•client economic risk

•quality of the client’s information system

•client’s control structure

•current market conditions and competitor actions

Important steps in the audit process

Understand the client and the industry. 1

4 Assess adequacy of evidence.

3 Directly test transactions and/or account balances.

2 Assess environment risk.

Nature of Audit TestingTwo basic types of audit evidence:

• The underlying accounting data.

• Corroborating information that validates the underlying accounting data.

Audit Procedures

Audit procedures vary according to the risk.

Vary with the three major phases of the audit.

Preliminary planning and risk analysis.

Understand and test system.

Test account balances or other business measurements.

Reliability of EvidenceMore Reliable:

•Directly observable evidence.

•Evidence derived from a well-controlled information system.

•Evidence from independent outside sources.

Reliability of EvidenceLess Reliable:

•Indirectly observable evidence.

•Evidence derived from a poorly controlled or easily overridden information system.

•Evidence from within the client’s organization.

Internal DocumentationReliability varies with:

•Quality of internal control.

•Fraud potential.

•Formality of the organization.

•Preparation of the document independently of the accounting system and management.

External Documentation

Generally considered to be highly reliable.

More reliable if auditor receives directly.

Paper vs. Electronic

Major challenge for auditors to determine which electronic data is reliable.

Computer systems can be designed to provide safeguards.

Auditor must continually examine nature of evidence.

Directional TestingTest for over- or understatement, not both.

Efficient because:

•Misstatements are more likely to occur in one direction.

•Can provide evidence about a complementary set of accounts.

•Some assertions are directional by nature.

Direct Tests of Account Balances

Types of Audit Procedures:

•Observation

•Physical examination

•Inquiries of client personnel

•Inquires of outside parties

•Examination of documents

•Recomputation or recalculation

Direct Tests of Account Balances (cont.)

•Reprocessing transactions

•Vouching of transactions

•Analytical procedures

Timing and Extent of Procedures

Auditor must determine when to do the procedure:

as of the balance sheet date

after the balance sheet date

at an interim date

Timing decisions based on:

risk, internal control, nature of the account and availability of audit staff.

Audit Programs and Documenting Evidence

Audit programsAudit programs

Specify which population to audit.Specify which population to audit.

Specify how much evidence to gather.Specify how much evidence to gather.

Specify procedures to be usedSpecify procedures to be used.

Documenting Audit Evidence

Audit working papers include:

•Evidence of planning, including the audit program.

•The client’s trial balance.

•Copies of selected internal/external documents.

•Auditor memos.

•Computer printouts of analysis and tests of clients controls.

•Auditor-generated analysis of account balances.

Characteristics of Good Audit Working PapersA heading.

Initials or signature of auditor.

Initials or signature of reviewer.

Description of work performed.

Assessment of evidence.

Tic marks and legend.

Index.

Cross references to related work papers.

Other Topics

•Paper vs. Electronic Working Papers.

•Importance of quality review.