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AUDIT
EVIDENCE
CHAPTER 7

7-1

CHAPTER 7 LEARNING OBJECTIVES

7-1 Contrast audit evidence with evidence used by other professions.

7-2 Identify the four audit evidence decisions that are needed to create
an audit program.
7-3 Specify the characteristics that determine the persuasiveness of
evidence.
7-4 Identify and apply the eight types of evidence used in auditing.
7-5 Know the types of analytical procedures and their purposes.
7-6 Identify how auditors incorporate data analytics and other advanced technologies
in an audit
7-7 Compute common financial ratios.
7-8 Understand the purposes of audit documentation.
7-9 Prepare organized audit documentation.

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OBJECTIVE 7-1
Contrast audit evidence with evidence
used by other professions.

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NATURE OF EVIDENCE
Table 7-1 contrasts audit evidence with legal and
scientific evidence.

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OBJECTIVE 7-2
Identify the four audit evidence
decisions that are needed to create
an audit program.

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AUDIT EVIDENCE DECISIONS

The auditor must make four major decisions
regarding what evidence to gather and how much to
accumulate:
1. Which audit procedures to use?
2. What sample size to select for a given procedure?
3. Which items to select from the population?
4. When to perform the procedures?
An audit program includes all of the above
information for a given audit.

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OBJECTIVE 7-3
Specify the characteristics that determine
the persuasiveness of evidence.

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PERSUASIVENESS OF EVIDENCE

Audit standards require that the auditor accumulate

sufficient appropriate evidence to support the opinion
issued.
The two determinants of the persuasiveness of evidence
are appropriateness and sufficiency.
Appropriateness of evidence depends on:
• Relevance of evidence
• Reliability of evidence

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PERSUASIVENESS OF EVIDENCE (CONT.)

Relevance of evidence means that the evidence must
pertain to or be relevant to the audit objective that is
being tested.
Reliability of evidence refers to the degree to which evidence is
believable or worthy of trust. Reliability depends on the following
characteristics:
1. Independence of provider
2. Effectiveness of client’s internal controls
3. Auditor’s direct knowledge
4. Qualifications of individuals providing the information
5. Degree of objectivity
6. Timeliness

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PERSUASIVENESS OF EVIDENCE (CONT.)

Sufficiency of evidence refers to the quantity of evidence obtained.
The sample size that is considered sufficient is affected by two
factors:
• The auditor’s expectation of misstatements
• The effectiveness of the client’s internal controls
Combined Effect—The persuasiveness of the evidence can be
evaluated only after considering the combination of
appropriateness and sufficiency.

In making decisions about audit evidence, both persuasiveness and

cost must be considered. The relationships among evidence
decisions and persuasiveness are illustrated in Table 7-2.

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Sufficient appropriate audit evidence

ISA (UK) 500

Sufficient Appropriate (Quality)
Audit Evidence
Quantity – Sufficient to support
the audit opinion Relevance Reliability
Factors to consider are: The evidence • External better than internal
• Risk assessment gathered must cover • Internal more reliable when
• Nature of accounting and the FS assertions control effective
internal control systems • Auditor obtained directly
• Materiality of the item Quality of better than indirectly or by
• Experience gained during evidence will also inference
previous audits affect the Quantity • Documentary better than oral
• Source and reliability of of evidence • Original documents more
information available reliable than
12 copies/faxes

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OBJECTIVE 7-4
Identify and apply the eight types of
evidence used in auditing.

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TYPES OF AUDIT EVIDENCE

Every audit procedure obtains one or more of the following
types of evidence:
1. Physical examination
2. Confirmation
3. Inspection
4. Analytical procedures
5. Inquiries of the client
6. Recalculation
7. Reperformance
8. Observation
Relationships among auditing standards, types of evidence, and the four
audit evidence decisions are shown in Figure 7-1.

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TYPES OF AUDIT EVIDENCE (CONT.)

1. Physical Examination—The inspection or count of a tangible asset by the auditor.
2. Confirmation—The receipt of a direct written response from a third party
verifying the accuracy of information that was requested by the auditor.
Information often confirmed is detailed in Table 7-3.
3. Inspection—The auditor’s examination of the client’s documents and records to
substantiate the information in the financial statements.
• Documents can be internal (prepared by the client’s organization) or external
(prepared or handled by someone outside the organization who is a party to
the transaction).
• Using documents to support recorded transactions (occurrence) is called
vouching.
• Testing from source documents to recorded amounts (completeness
objective) is called tracing.

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PHYSICAL EXAMINATION

• Advantages of physical examination:

Assurance on the existence of the asset, quantity
and description of the asset or asset’s condition.
• Disadvantages of physical examination:
Providing little or no assurance on the ownership
objectives and proper valuation of asset
Exercise: Describe the physical examination of cash
on hand

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TYPES OF AUDIT EVIDENCE (CONT.)

1. Physical Examination—The inspection or count of a tangible asset by the auditor.
2. Confirmation—The receipt of a direct written response from a third party
verifying the accuracy of information that was requested by the auditor.
Information often confirmed is detailed in Table 7-3.
3. Inspection—The auditor’s examination of the client’s documents and records to
substantiate the information in the financial statements.
• Documents can be internal (prepared by the client’s organization) or external
(prepared or handled by someone outside the organization who is a party to
the transaction).
• Using documents to support recorded transactions (occurrence) is called
vouching.
• Testing from source documents to recorded amounts (completeness
objective) is called tracing.

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TYPES OF CONFIRMATION
• Positive confirmation: the recipient is request to return the
confirmation in all circumstances.
• Open confirmation: confirmation not included the figure to be
confirmed and this will be filled in by the responses of the third
party.
• Closed confirmation: confirmation included the figure to be
confirmed and the third party will confirm whether this figure is
correct or not , if not, differences required to be included.
• Negative confirmation: the recipient is request to response only
when the information is incorrect.

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TYPES OF AUDIT EVIDENCE (CONT.)

1. Physical Examination—The inspection or count of a tangible asset by the auditor.
2. Confirmation—The receipt of a direct written response from a third party
verifying the accuracy of information that was requested by the auditor.
Information often confirmed is detailed in Table 7-3.
3. Inspection—The auditor’s examination of the client’s documents and records to
substantiate the information in the financial statements.
• Documents can be internal (prepared by the client’s organization) or external
(prepared or handled by someone outside the organization who is a party to
the transaction).
• Using documents to support recorded transactions (occurrence) is called
vouching.
• Testing from source documents to recorded amounts (completeness
objective) is called tracing.

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DOCUMENTATION
• Direction of testing:
Tracing (completeness)
Source
Ledger and journal
document
Vouching (Occurrence)

Vouching refers to selecting an item for testing from accounting journals or

ledgers and then examining the supporting source document => testing for
occurrence
Tracing refers to selecting an accounting transaction and the following it in
the journal and ledger => testing for completeness.

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TYPES OF AUDIT EVIDENCE (CONT.)

4. Analytical Procedures—The evaluation of financial information through analysis of
plausible relationships among financial and nonfinancial data and are required
during planning and completion phases of all audits. Purposes of analytical
procedures include:
• Understand the Client’s Industry and Business—Used in planning to gain
knowledge about the client.
• Assess the Entity’s Ability to Continue as a Going Concern—Many ratios can be
an indicator of potential financial problems.
• Indicate the Presence of Possible Misstatements in the Financial Statements—
The presence of unusual fluctuations noted in comparing current and prior
years could signal misstatements.
• Provide Evidence Supporting an Account Balance—If reliable relationships
exist, substantive analytical procedures can be used to support account
balances.

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TYPES OF AUDIT EVIDENCE (CONT.)

5. Inquiry—Obtaining written or oral information from the client in

response to auditor questions. Usually not considered conclusive
unless it is corroborated.
6. Recalculation—Rechecking a sample of calculations made by the
client.
7. Reperformance—The auditor’s test of client accounting procedures
or controls.
8. Observation—Watching a process or procedure being performed by
others.

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INQUIRY
Ex: inquiries of client personnel or management to understanding client’s
business or internal control.
AD: easy to obtain this evidence and widely used in audit.
DAD: Inquiry is not from independent sources and may be biased in the client’s
favor => is not considered high reliability => gather additional corroborative
evidence to support the client’s responses

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Closing question help the auditor to confirm the known matter. This question is to limit the
answers of interviewees. The answer of this type of question used the word “Yes or No”.
For example:
• Do you perform stock count every month?
• Do you carry out physical examination of cash on hand every day?
• Are the documents pre-numbered?
• Do you delete the name of employees from payroll report when he/she stopped working?
• Opening questions helps the auditor to obtain detail and adequate answers to collect
additional information. This type of question is normally used the word “what”, “why”,
“how”
• For example:
• How do you perform the stock count?
• Which payment procedures do you carry out?
• What is recruitment process?

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TYPES OF AUDIT EVIDENCE (CONT.)

5. Inquiry—Obtaining written or oral information from the client in

response to auditor questions. Usually not considered conclusive
unless it is corroborated.
6. Recalculation—Rechecking a sample of calculations made by the
client. Ex: recalculate the depreciation expense, interest expense,…
7. Reperformance—The auditor’s test of client accounting procedures
or controls. Ex: the auditor may compare the price on an invoice to a
approved price list.
8. Observation—Watching a process or procedure being performed by
others.

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OBSERVATION
Ex1: the auditor observes the separation of duties such as:
- Separation of custody of assets from accounting,
- Separation of operation responsibility from record-keeping responsibility.
Ex2: observe the condition of inventory whether it is obsolete or slow-moving

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OBSERVATION
• AD: easy to obtain this evidence and widely used in audit, low cost.

• DAD: Observation is rarely sufficient by itself because there is a risk that

the client personnel involved in those activities are aware of the auditor’s
presence.

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TYPES OF AUDIT EVIDENCE (CONT.)

Appropriateness of Types of Evidence—Table 7-4 details the criteria to

determine appropriateness. Conclusions from the criteria:
• The effectiveness of a client’s internal controls has significant
influence on the reliability of most types of audit evidence,
especially internal documentation and analytical procedures.
• Physical examination and recalculation involve the auditor’s
direct knowledge and are likely to be highly reliable.
• Inquiry alone is usually not sufficient to provide appropriate
evidence to satisfy any audit objective.

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TYPES OF AUDIT EVIDENCE (CONT.)

Cost of Types of Evidence:
• Most expensive:
• Physical examination
• Confirmation
• Moderately costly:
• Inspection
• Analytical procedures
• Reperformance
• Least expensive:
• Observation
• Inquiries of the client
• Recalculation
Terms used in audit procedures are defined in Table 7-5.

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OBJECTIVE 7-5
Know the types of analytical procedures
and their purposes.

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ANALYTICAL PROCEDURES
Purposes of Analytical Procedures During the Audit Engagement:
1. Analytical procedures are required in the planning phase as
part of risk assessment to understand the client’s business
and industry.
2. Analytical procedures are often done during the testing phase
of the audit as substantive tests in support of an account
balance.
3. Analytical procedures are required during the completion
phase of the audit, serving as a final review for material
misstatements.

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ANALYTICAL PROCEDURES (CONT.)

Types of Analytical Procedures—Auditors compare client data with:

1. Industry data
2. Similar prior-period data
3. Client-determined expected results
4. Auditor-determined expected results

Internal comparisons and relationships are detailed in Table 7-6.

An example of a substantive analytical procedure is included in Figure 7-2.

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OBJECTIVE 7-6
Use of Data Analytics and other Advanced Technologies

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 Audit Data Analytics

The AICPA’s Guide to Data Analytics defines audit data analytics as follows:

“Audit data analytics are the science and art of discovering and analyzing
patterns, identifying anomalies, and extracting other useful information in
data underlying or related to the subject matter of an audit through analysis,
modeling, and visualization for purpose of planning or performing the
audit.”

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 Audit Data Analytics (cont.)

 The pervasive use of information technologies by client organizations and the
increased availability of large amounts of data provide opportunities for
auditors to take advantage of IT-based audit data analytics tools throughout the
entire audit process.
 ADAs allow the auditor to perform analysis of large amounts of complex data,
sometimes involving 100 percent of the population of transactions or account
balances.
 ADAs are used by auditors throughout the entire audit process from audit
planning through completion of the audit.

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 Audit Data Analytics (cont.)

Fundamental considerations to evaluate the appropriate use of ADAs:
 Accessing the Data: IT-based systems used by clients can vary extensively across different
organizations and within the same entity. Because of the confidential and proprietary nature of
much of a client’s data, auditors may face reluctance from client management about access to client
systems and data.
 Preparing the Data: data sets often contain errors that need to be scrubbed before analysis. Data
fields that are supposed to contain data may be missing key data or it may be entered in formats
that are not consistent across entries.
 Evaluate the Relevance and Reliability of the Data: Data come from sources internal or external
to the client, which may affect the reliability of the data.
 Address Circumstances in Which an ADA Identifies a Large Number of Exceptions
for Further Consideration: ADA may identify a large number of items that represent exceptions
that require some form of auditor consideration and follow-up.
 Document Use of ADA: the auditor should document the use of the ADA in the auditor’s working
papers.
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 Use of Advanced Technologies in the Audit

 Many of the advances involve artificial intelligence (AI) whereby computers that
perform routine, repetitive processes begin to learn or develop “intelligence” that
allows them to recognize patterns and take actions automatically.
 3 different types of AI that are beginning to be used in an audit context:
 Robotics
 Machine Learning
 Deep Learning

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 Robotics
 Computers can be programmed to perform rules-based processes at rapid speed.
Often referred to as “bots”, these technologies can be used to automate processes that
are based on prescribed protocols with high levels of precision and efficiency.
 Audit bots may be used by the auditor to perform activities that require repetition,
such as copying and pasting data between applications, or reconciling or cross-
referencing data between different systems.
 For example, an auditor may create a bot to read a client’s accounts receivable sub-
ledger to pull customer names, addresses, and account details that the bot then uses to
prepare and electronically mail individual confirmations for account receivable testing.
 The use of bots in the audit will free auditors to focus on higher-value activities in the
audit.

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 Machine Learning
 Machine learning involves the use of statistical techniques that allow the computer to
“learn” from the data to progressively improve the performance of a specific task.
 As auditors use ADAs to analyze 100 percent of a population of transactions or
accounts, machine learning may allow the computer to “learn” from the auditor’s
evaluation of exceptions flagged by the ADA. As the auditor repeatedly accepts or
rejects items flagged by the ADA for follow-up, the machine may begin to recognize
patterns in the auditor’s conclusions that can then be applied by the machine as it
identifies additional data points for review.
 In this example, the computer learns to apply better screening of individual
transactions so that it is more capable of segregating normal transactions from those
that represent true exceptions as the ADA is performed.

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 Deep Learning
 Deep learning technologies: computers are trained to recognize large amounts of data
that would be impossible for humans to process.
 The “learning process” involves reading vast amounts of data in a repeated fashion to
allow the computer to better understand true exceptions and lower its error rate.
 The exploration of driverless vehicles is an example of how deep learning is being
explored today to perform the complex task of driving in a constantly changing
environment and surrounding conditions.
 While deep learning is still in its early exploration phase, the accounting profession is
exploring how this technology might eventually be useful in the future to perform
complex analyses and judgments in the audit of financial statements. The audit of the
future may involve a mix of computers and people working side-by-side.

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OBJECTIVE 7-7
Compute common financial ratios.

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COMMON FINANCIAL RATIOS

Financial ratios fall into several categories:
• Short-Term Debt-Paying Ability:
• Cash ratio = (cash + Marketable securities)/Current liabilities
• Quick ratio= Cash + MS + Net AR)/ Current liabilities
• Current ratio = Current Assets/ Current liabilities
• Liquidity Activity Ratios:
• Accounts receivable turnover = Net Sale/Average gross receivables
• Days to collect receivables= 365 days/AR turnover
• Inventory turnover = Cost of good sold/average inventory
• Days to sell inventory = 365 days/inventory turnover

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COMMON FINANCIAL RATIOS (CONT.)

• Ability to Meet Long-Term Debt Obligations:

• Debt to equity = total liabilities/total equity
• Times interest earned = operating income/interest expense
• Profitability Ratios:
• Earnings per share = net income/ average common share outstanding
• Gross profit percentage = (net sales – COS)/Net sales
• Profit margin = operating income/Net sales
• Return on assets = income before taxes/ average total assets
• Return on common equity= (income before taxes – preferred
dividends)/ average stockholder’s equity)
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OBJECTIVE 7-8
Prepare organized audit documentation.

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AUDIT DOCUMENTATION
Audit documentation is the record of the audit procedures
performed, relevant audit evidence, and conclusions the auditor
reached.
Purposes of Audit Documentation:
• Basis for planning the audit
• Record of the evidence accumulated and the results of the tests
• Data for determining the proper type of audit report
• Basis for review by supervisors and partners
Ownership of the Audit Files: All audit files are the property of
the auditor.

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AUDIT DOCUMENTATION (CONT.)

Confidentiality of Audit Files:

The AICPA Code of Professional Conduct states that a member in public
practice shall not disclose any confidential client information without the
specific consent of the client.
Requirements for Retention of Audit Documentation:
• Auditing standards require records of private companies be retained
for a minimum of five years.
• Sarbanes-Oxley Act requires auditors of public companies to maintain
audit files for a minimum of seven years.

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AUDIT DOCUMENTATION (CONT.)

The contents and organization of a typical set of audit files is illustrated in

Figure 7-3. The type of audit documentation and the way it is arranged in the
files is logical although firms may vary in their approaches.
Permanent Files: Contain data of a historical or continuing nature. These
provide a convenient source of information that is used from year to year:
• Copies of company documents such as articles of incorporation, bylaws, bond
indentures, and long-term contracts
• Analyses of accounts from previous years that have continuing importance
• Information related to understanding internal controls and assessing control
risk
• Results of analytical procedures from prior years’ audits for comparison

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AUDIT DOCUMENTATION (CONT.)

Current Files: Includes all documentation for the current year audit including:
• Audit Program
• Working Trial Balance—Each line in the trial balance is supported by a lead
schedule. A typical lead schedule for Cash is included in Figure 7-4.
• Adjusting Entries—Auditors propose adjusting entries for material
misstatements. An adjusting entry to Cash is illustrated in Figure 7-4.
• Supporting Schedules—Major types:
• Analysis
• Trial balance or list
• Reconciliation of amounts
• Substantive analytical procedures
• Summary of procedures
• Examination of supporting documentation
• Informational
• Outside documentation
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AUDIT DOCUMENTATION (CONT.)

Preparation of Audit Documentation—Audit documentation should be in
sufficient detail to provide a clear understanding of the work performed,
evidence obtained, and conclusions reached.
Documentation should have these characteristics:
• Identified with the client’s name, period covered, description of the
contents, initials of the preparer, date of preparation, and an index
code.
• Files should be indexed and cross-referenced to aid in organization.
• Documentation should clearly indicate the audit work performed
through memos, initialing the procedures in the audit program, or tick
marks on the schedules.
• Include sufficient information to fulfill the audit objectives.
• Conclusions reached about the segment of the audit should be clearly
stated.

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