The document discusses audit evidence and procedures. It defines the components of audit risk as inherent risk, control risk, and detection risk. It explains that auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level. The evidence should be relevant, reliable, directly obtained by the auditor when possible, and in documentary form. Audit procedures include risk assessment, tests of controls, analytical procedures, and tests of account balances, transactions and disclosures. Changing the nature, timing, or extent of procedures can alter the scope of the audit work performed.

1. 5-1
Evidence & Documentation

2. Evidence to Meet The Challenge
The possibility exists that the auditors may
unknowingly fail to appropriately modify their opinion
on financial statements that are materially misstated
◦ This is the risk that the auditors will issue an unqualified
opinion on financial statements that contain a material
departure from GAAP.
Auditors must obtain sufficient appropriate audit
evidence to reduce audit risk to a low level in every
audit.

3. Financial Statements as Assertions
Made by Management
Relevant assertions are those that, without regard for controls, have a
reasonable possibility of containing a material misstatement;
Types of Assertions
◦ Account balances (Accounts)
◦ Classes of transactions and events (Transactions)
◦ Presentation and disclosure (Disclosures)

4. Financial Statement Assertions: Auditing Standards Board
and International Standards
Accounts Transactions Disclosures
Existence Occurrence Occurrence
Rights and
obligations
Rights and
obligations
Completeness Completeness Completeness
Valuation and
allocation
Accuracy Accuracy and
valuation
Cutoff
Classification Classification and
understandability

5. Combining Assertions
Existence or Occurrence—Assets, liabilities, and equity interests exist and
recorded transactions have occurred
Rights and Obligations—The company holds rights to the assets, and
liability are the obligations of the company
Completeness—All assets, liabilities, equity interests, and transactions that
should have been recorded have been recorded
Cutoff—Transactions and events have been recorded in the correct
accounting period
Valuation, Allocation and Accuracy—All transactions, assets, liabilities and
equity interests are included in the financial statements at proper amounts
Presentation and Disclosure—Accounts are described and classified in
accordance with generally accepted accounting principles, and financial
statement disclosures are complete, appropriate, and clearly expressed

6. a.Which of the following is not a financial statement assertion made by
management?
1. Existence of recorded assets and liabilities.
2. Completeness of recorded assets and liabilities.
3. Valuation of assets and liabilities.
4. Effectiveness of internal control.
Answer: 4

7. Auditors consider financial statement assertions to identify appropriate audit procedures. For
items a through f, match each assertion with the statement that most closely approximates its meaning.
Each statement may be used only once.
Assertion Statement
a. Completeness
b. Cutoff
c. Existence and
occurrence
d. Presentation and
disclosure
e. Rights and obligations
f. Valuation
1. There is such an asset.
2. The company legally owns the assets.
3. All assets have been recorded.
4. Transactions are recorded in the correct
accounting period.
5. Assets are recorded at proper amounts.
6. Assets are properly classified.

8. Assertion Statement
a. Completeness All assets have been recorded.
b. Cutoff Transactions are recorded in the correct accounting period.
c. Existence and occurrence There is such an asset.
d. Presentation and disclosure Assets are properly classified.
e. Rights and obligations The company legally owns the assets.
f. Valuation Assets are recorded at proper amounts.

9. Audit Risk Model
Risk of Material X Risk That Auditors Fail to
Audit Risk (AR) = Misstatement Detect Material Misstatements
= (Inherent X Control) X Detection
Risk (IR) Risk (CR) Risk (DR)
(IR) Inherent Risk—Risk of a material misstatement occurring in an
assertion assuming no related internal controls.
(CR) Control Risk—Risk that a material misstatement in an assertion will
not be prevented or detected on a timely basis by the company’s
internal control.
(DR) Detection Risk—Risk that the auditors’ procedures will lead them to
conclude that a material misstatement does not exist in an assertion
when in fact such misstatement does exist.

10. Inherent Risk
Factors that affect inherent risk:
◦ Nature of the client and its environment
◦ Nature of the particular financial statement element
Business characteristics indicative of high inherent risk:
◦ Inconsistent profitability of client
◦ Operating results highly sensitive to economic factors
◦ Going concern problems
◦ Large known and likely misstatements detected in prior audits
◦ Substantial turnover, questionable reputation, or inadequate accounting
skills of management

11. Assertions with High Inherent Risk
◦ Difficult transactions or balances
◦ Complex calculations
◦ Difficult accounting issues
◦ Significant judgment by management
◦ Valuations that vary significantly based on economic
factors

12. b.Which of the following business characteristics is not indicative of high
inherent risk?
1. Operating results that are highly sensitive to economic factors.
2. Large likely misstatements detected in prior audits.
3. Substantial turnover of management.
4. A large amount of assets.
Answer: 4

13. State whether each of the following statements is correct or incorrect concerning audit risk and its
components—inherent risk, control risk, and detection risk.
a. The risk of material misstatement is composed of the three components of audit risk.
b. Inherent risk is the possibility of material misstatement before considering the client's internal
control.
c. Less control risk means an increase in the risk of material misstatement.
d. Detection risk does not exist when no audit is performed.
e. Rather than restrict detection risk through the performance of more substantive procedures,
auditors assess it.
f. Absent any other changes, an increase in the risk of material misstatement results in an
increase in audit risk.
g. Audit risk refers to the possibility that the auditors may unknowingly fail to appropriately
modify their opinion on financial statements that are materially or immaterially misstated.
h. Both inherent risk and control risk exist independently of the audit of financial statements.

14. a. The risk of material misstatement is composed of the three components of audit risk. Incorrect
b.
Inherent risk is the possibility of material misstatement before considering the client’s internal control. Correct
c. Less control risk means an increase in the risk of material misstatement. Incorrect
d. Detection risk does not exist when no audit is performed. Correct
e.
Rather than restrict detection risk through the performance of more substantive procedures, auditors
assess it.
Incorrect
f.
Absent any other changes, an increase in the risk of material misstatement results in an increase in audit
risk.
Correct
g.
Audit risk refers to the possibility that the auditors may unknowingly fail to appropriately modify their
opinion on financial statements that are materially or immaterially misstated.
Incorrect
h. Both inherent risk and control risk exist independently of the audit of financial statements. Correct
a. The risk of material misstatements is composed of inherent risk and control risk.
c. A decrease in control risk, absent other changes, results in a decrease in the risk of material misstatement.
d. Detection risk is a function of the audit and its procedures. If there is no audit there is no measure of detection risk.
e.
This is backwards. Auditors restrict detection risk through the performance of more substantive procedures. Auditors assess
inherent risk and control risk.
g. The error is the “or immaterially.” Audit risk deals with material misstatements.

15. Transaction Types
Routine
◦ Recurring financial statement activities recorded in the accounting records
in the normal course of business
◦ Lower inherent risk
Nonroutine
◦ Involve activities that occur only periodically such as the taking of physical
inventories
◦ High inherent risk
Estimation
◦ Activities that create accounting estimates
◦ Higher inherent risk

16. Appropriateness of Audit Evidence
Auditor must obtain sufficient appropriate audit evidence.
To be appropriate audit evidence must be:
◦ Relevant
◦ Reliable
Principles—Audit evidence is ordinarily more reliable when
it is
◦ Obtained from knowledgeable independent sources outside the
company rather than nonindependent sources
◦ Generated internally through a system of effective controls rather
than ineffective controls.
◦ Obtained directly by the auditor rather than indirectly or by
inference
◦ Documentary in form rather than oral
◦ Provided by original documents rather than copies

17. e. Of the following, which is the least reliable type of audit evidence?
1. Confirmations mailed by outsiders to the auditors.
2. Correspondence between the auditors and suppliers.
3. Copies of sales invoices inspected by the auditors.
4. Canceled checks returned in the year-end bank statement directly to the
client.
Answer:3

18. Audit Procedures
Risk assessment procedures
◦ To obtain an understanding of the client and its
environment, including its internal control, to assess the
risks of material misstatement
Further Audit Procedures
◦ Tests of controls
◦ When appropriate, to test the operating effectiveness of controls in preventing
material misstatements
◦ Substantive procedures
◦ To detect material misstatements at relevant assertion level.
◦ Include
◦ (a) analytical procedures
◦ (b) tests of details of account balances, transactions and disclosures

19. 5-19
Plan Audit
Obtain Understanding of Client and Its
Environment Including Internal Control
Assess Risks of Misstatement and Design
Further Tests
Perform Substantive Procedures
Complete the Audit
Issue Audit Report
Perform Tests
of Controls
Audit Diagram

20. Substantive Procedures
Analytical procedures
Tests of details
◦ Tests of account balances
◦ Tests of classes of transactions
◦ Tests of disclosures
◦ One may change the scope of audit procedures by changing
the NTE, or re-ordered as NET:
◦ Nature (type and form)
◦ Timing (when performed)
◦ Extent (quantity of evidence obtained)

21. 5-21
Nature and Timing of Procedures
Holding the extent of procedures constant, one may increase the scope of
procedures (make them more effective) by either changing the
◦ Nature—obtain more reliable evidence - often externally
generated evidence.
◦ Timing—wait until year-end to obtain evidence from the entire
set of transactions as contrasted to performing interim testing,
say two months prior to year-end and simply updating those
procedures.

22. 5-22
Extent of Procedures
Holding other factors such as the nature and
timing of procedures constant:
◦The greater the risk of material misstatement,
the greater the needed extent of substantive
procedures
◦The main way to increase the extent of audit
procedures is to examine more items
◦Sample sizes should reduce detection risk to
restrict audit risk to a low level

23. 5-23
Types of Audit Procedures and Examples

24. 5-24
Types of Audit Procedures and Examples

25. Auditors perform audit procedures to obtain audit evidence that will allow them to draw reasonable
conclusions as to whether the client's financial statements follow generally accepted accounting
principles. Match each audit procedure with its type. Each type of audit procedure is used; one is used
twice.
Audit Procedures Type of Audit Procedure
g. Prepare a flowchart of internal
control over sales.
h. Calculate the ratio of bad debt
expense to credit sales.
i. Determine whether disbursements
are properly approved.
j. Confirm accounts receivable.
k. Compare current financial
information with comparable prior
periods.
7. Analytical procedures
8. Tests of controls
9. Risk assessment procedures
(other than analytical
procedures)
10. Test of details of account
balances, transactions, or
disclosures

26. Audit Procedures Type of Audit Procedure
g.Prepare a flowchart of internal control over
sales Risk assessment procedures (other than analytical
procedures).
h.Calculate the ratio of bad debt expense to
credit sales
Analytical procedures.
i. Determine whether disbursements are
properly approved
Tests of controls.
j. Confirm accounts receivable
Test of details of account balances, transactions, or
disclosures.
k.Compare current financial information with
comparable prior periods
Analytical procedures.

27. Analytical Procedures
Timing of analytical procedures throughout the audit
◦ Risk assessment (sometimes referred to as planning analytical
procedures)
◦ Substantive procedures
◦ Final review
Steps involved
◦ Develop expectation of account (or ratio) balance
◦ Determine amount of difference that can be accepted without investigation
◦ Compare the company’s account (ratio) with the expectation
◦ Investigate and evaluate significant differences

28. 5-28
Analytical Procedures
Developing an expectation
◦ Prior period information
◦ Anticipated results
◦ Relationships among elements of financial information within a
period
◦ Industry information
◦ Relationships between financial information and relevant
nonfinancial data.

29. Analytical Procedures
Types of Expectations
◦ Trend analysis—analyze changes in accounts of a company over
time
◦ Ratio analysis — compare relationships between two or more
financial statement accounts or comparisons of account
balances to nonfinancial data
◦ Liquidity (e.g., current ratio)
◦ Leverage (e.g., debt to equity)
◦ Profitability (e.g., gross profit percentage)
◦ Activity (e.g., inventory turnover)

31. f. Analytical procedures are most likely to detect:
1. Weaknesses of a material nature in internal control.
2. Unusual transactions.
3. Noncompliance with prescribed control activities.
4. Improper separation of accounting and other financial duties.
Answer: 2

32. Ratio Analysis
◦ Horizontal analysis
◦ Review ratios over time
◦ Cross sectional analysis
◦ Analyze ratios of similar firms at a point in time
◦ Vertical analysis
◦ Analyze relationships within a period
◦ “Common size” statements prepared
◦ Other methods
◦ Regression analysis, reasonableness test

34. Houseco, an audit client of Jones, CPA, for the past five years, is a manufacturer of various household
products. Approximately four years ago, Houseco developed a better toaster than had been available
and sales took off, especially during the most recent two years, 20X7 and 20X8. Currently, the company
controls approximately 25 percent of the toaster market in the United States. In addition, the company
manufactures other products, including vacuum cleaners, floor polishers, and electric fondue pots.
Much of the increased sales performance is due to Donald Skaldon, who became the chief executive
officer in 20X4. Donald and several other officers were able to accomplish a leveraged stock buyout in
20X6. This seems to have worked out very well since Donald suggests that his net worth grew from less
than $300,000 to well over $5 million due to increases in the value of the common stock he holds in the
company. He is also excited since the company's unaudited results show earnings per share of $1.21,
one cent more than the most optimistic analysts had projected. He points out to Jones that sales are up
over 38 percent compared to the previous year and net income has increased by 54 percent. All is well.
Jones is beginning the risk assessment analytical procedures for the 20X8 audit to obtain information to
help plan the nature, timing, and extent of other audit procedures. More specifically, he wants to
identify areas that may represent specific risks relevant to this year's audit.

37. 5-37
Data Analytics
Data analytics is the process of using related and unrelated data sets to
provide insights into decisions.
CPA firms are increasingly using data analytic approaches to improve
risk assessment, tests of controls and substantive procedures.
◦ In risk assessment, sophisticated data analytics can improve auditors’
assessments of risk by significantly increasing the sources of data used.
◦ In tests of controls, data analytics may allow the auditors to use technology
to test 100 percent of the items in a population by relating data from
multiple sources
◦ Substantive procedures may be improved by using data from a number of
data sources to improve the efficiency and effectiveness of the procedures.

38. Auditing Accounting Estimates
Review and test management’s process for developing the
estimate.
Independently develop an estimate to compare to management’s
estimate.
Review subsequent events or transactions bearing on the
estimate.

39. g. Which of the following is not a primary approach to auditing an accounting
estimate?
1.Review and test management’s process for developing the estimate.
2. Review subsequent transactions.
3. Confirm the amounts.
4. Develop an independent estimate.
Answer: 3

40. Auditing Fair Values
Inputs to use in applying valuation techniques (FAS 157)
◦ Level 1 – inputs of observable quoted prices in active markets for
identical assets or liabilities
◦ Ex. A closing stock price in WSJ
◦ Level 2 – inputs of observable quoted prices, generally for similar
assets or liabilities in active markets
◦ Ex. Company discounts future cash flows on its not publicly traded debt
securities at rate used by market for publicly traded debt securities
◦ Level 3 – inputs that are unobservable for the assets or liability
◦ Ex. A private company uses judgment to determine a proper rate to discount
the future cash flows of its not publicly traded securities

41. Related Party Transactions
Disclosure requirements must be met
Primary challenge is identifying undisclosed related party transactions
◦ Determine related parties
◦ Inquiries of management
◦ Review SEC filings, stockholder’s listings and conflict-of-interest
statements
◦ Be alert for transactions with related parties and any transactions with
unusual terms

42. Audit Documentation
Primary functions:
•Support the auditors’ compliance with auditing standards
•Support the auditors’ opinion
Secondary functions:
•Assist continuing and new audit team members in planning
and performing the audit
•Serves as a record of matters of continuing audit interest
•Assists in supervision and review of the audit
•Demonstrates the accountability of team members
•Assists internal reviewers, external peer reviewers, PCAOB
inspectors, and successor auditors in performing their roles

43. Sufficiency of Audit Documentation
Audit documentation should be sufficient to:
◦ Enable an experienced auditor to understand the work
performed and the significant conclusions reached
◦ Identify who performed and reviewed the work
◦ Show that the accounting agree or reconcile to the financial
statements
Audit documentation should include all significant
audit findings and the actions taken to address them

44. Documentation (Working Papers)
Audit administrative working papers
Working trial balance
Lead schedules
Adjusting journal entries and reclassification entries
Supporting schedules
Analysis of a ledger account
Reconciliations
Computational working papers
Corroborating documents

45. Types of Working Files
Current files
◦Current year working papers
◦Index and cross-referencing
Permanent files
◦Items of continuing audit interest

46. i. In what section of the audit working papers would a long-
term lease agreement be filed?
1. Current working paper file.
2. Permanent working paper file.
3. Lead schedule file.
4. Corroborating documents file.
Answer: 2

47. d.Which of the following statements best describes why auditors investigate
related party transactions?
1. Related party transactions generally are illegal acts.
2. The substance of related party transactions may differ from their form.
3. All related party transactions must be eliminated as a step in preparing
consolidated financial statements.
4. Related party transactions are a form of management fraud.
Answer: 2

49. Preparation of a Working Paper