CHAPTER FIVE

AUDIT EVIDENCE

5.1. INTRODUCTION

The foundation of any audit is the evidence obtained and evaluated by the auditor. The auditor
must have the knowledge and skill to accumulate sufficient appropriate evidence on every audit
to meet the standards of the profession. This chapter deals with the types of evidence decisions
auditors make, the evidence available to auditors, and the use of that evidence in performing
audits and documenting
5.2. NATURE OF AUDIT EVIDENCE
Evidence was defined as any information used by the auditor to determine whether the
information being audited is stated in accordance with the established criteria. The information
varies greatly in the extent to which it persuades the auditor whether financial statements are
fairly stated. Evidence includes information that is highly persuasive, such as the auditor’s count
of marketable securities, and less persuasive information, such as responses to questions of client
employees. The use of evidence is not unique to auditors. Evidence is also used extensively by
scientists, lawyers, and historians. For example, most people are familiar with legal dramas on
television in which evidence is collected and used to argue for the guilt or innocence of a party
charged with a crime. In legal cases, there are well-defined rules of evidence enforced by the
judge for the protection of the innocent.

3.3. AUDIT EVIDENCE DECISIONS

A major decision facing every auditor is determining the appropriate types and amounts of
evidence needed to be satisfied that the client’s financial statements are fairly stated.
There are four decisions about what evidence to gather and how much of it 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

1
Audit procedure: is the detailed instruction that explains the audit evidence to be obtained
during the audit. It is common to spell out these procedures in sufficiently specific terms so an
auditor may follow these instructions during the audit.
For example, the following is an audit procedure for the verification of cash disbursements:

Examine the cash disbursements journal in the accounting system and compare the payee, name,
amount, and date with online information provided by the bank about checks processed for the
account.
Sample size: Once an audit procedure is selected, auditors can vary the sample size from one to
all the items in the population being tested. In an audit procedure to verify cash disbursements,
suppose 6,600 checks are recorded in the cash disbursements journal.
The auditor might select a sample size of 50 checks for comparison with the cash disbursements
journal. The decision of how many items to test must be made by the auditor for each audit
procedure. The sample size for any given procedure is likely to vary from audit to audit.

Items to select: After determining the sample size for an audit procedure, the auditor must
decide which items in the population to test. If the auditor decides, for example, to select
50cancelled checks from a population of 6,600 for comparison with the cash disbursements
journal, several different methods can be used to select the specific checks to be examined. The
auditor can (1) select a week and examine the first 50 checks, (2) select the 50 checks with the
largest amounts, (3) select the checks randomly, or (4) select those checks that the auditor thinks
are most likely to be in error. Or, a combination of these methods can be used.

Timing: An audit of financial statements usually covers a period such as a year. Normally an
audit is not completed until several weeks or months after the end of the period. The timing of
audit procedures can therefore vary from early in the accounting period to long after it has ended.
In part, the timing decision is affected by when the client needs the audit to be completed. In the
audit of financial statements, the client normally wants the audit completed 1 to 3 months after
year-end. The SEC currently requires that all public companies file audited financial statements
with the SEC within 60 to 90days of the company’s fiscal year-end, depending on the company’s
size. However, timing is also influenced by when the auditor believes the audit evidence will be

2
 most effective and when audit staff is available. For example, auditors often prefer to do counts
of inventory as close to the balance sheet date as possible.

Audit programs
The list of audit procedures for an audit area or an entire audit is called an audit program. The
audit program always includes a list of the audit procedures, and it usually includes sample sizes,
items to select, and the timing of the tests. Normally, there is an audit program, including several
audit procedures, for each component of the audit. Therefore, there will be an audit program for
accounts receivable, one for sales, and soon.
Many auditors use electronic audit software packages to generate audit programs. These software
programs help the auditor address risks and other audit planning considerations and select
appropriate audit procedures.

3.4. PERSUASIVENESS OF AUDIT EVIDENCE

Audit standards require the auditor to accumulate sufficient appropriate evidence to support the
opinion issued. Because of the nature of audit evidence and the cost considerations of doing an
audit, it is unlikely that the auditor will be completely convinced that the opinion is correct.
However, the auditor must be persuaded that the opinion is correct with a high level of
assurance. By combining all evidence from the entire audit, the auditor is able to decide when he
or she is persuaded to issue an audit report.
The two determinants of the persuasiveness of evidence are appropriateness & sufficiency
A. Appropriateness of evidence: is a measure of the quality of evidence, meaning its relevance
and reliability in meeting audit objectives for classes of transactions, account balances, and
related disclosures. If evidence is considered highly appropriate, it is a great help in persuading
the auditor that financial statements are fairly stated.
Note that appropriateness of evidence deals only with the audit procedures selected.
Appropriateness cannot be improved by selecting a larger sample size or different population
items. It can be improved only by selecting audit procedures that are more relevant or provide
more reliable evidence.
Relevance of Evidence: Evidence must pertain to or be relevant to the audit objective that the
auditor is testing before it can be appropriate. For example, assume that the auditor is concerned

3
that a client is failing to bill customers for shipments (completeness transaction objective). If the
auditor selects a sample of duplicate sales invoices and traces each to related shipping
documents, the evidence is not relevant for the completeness objective and therefore is not
appropriate evidence for that objective. A relevant procedure is to trace a sample of shipping
documents to related duplicate sales invoices to determine whether each shipment was billed.
The second audit procedure is relevant because the shipment of goods is the normal criterion
used for determining whether a sale has occurred and should have been billed. By tracing from
shipping documents to duplicate sales invoices, the auditor can determine whether shipments
have been billed to customers. In the first procedure, when the auditor traces from duplicate sales
invoices to shipping documents, it is impossible to find unbilled shipments.
Relevance can be considered only in terms of specific audit objectives, because evidence may be
relevant for one audit objective but not for a different one. In the previous shipping example,
when the auditor traced from the duplicate sales invoices to related shipping documents, the
evidence was relevant for the occurrence transaction objective. Most evidence is relevant for
more than one, but not all, audit objectives.
Reliability of Evidence: Reliability of evidence refers to the degree to which evidence can be
believable or worthy of trust. Like relevance, if evidence is considered reliable it is a great help
in persuading the auditor that financial statements are fairly stated. For example, if an auditor
counts inventory, that evidence is more reliable than if management gives the auditor its own
count amounts.
Reliability, and therefore appropriateness, depends on the following six characteristics of reliable
evidence:
1. Independence of provider. Evidence obtained from a source outside the entity is more
reliable than that obtained from within. Communications from banks, attorneys, or customers is
generally considered more reliable than answers obtained from inquiries of the client. Similarly,
documents that originate from outside the client’s organization, such as an insurance policy, are
considered more reliable than are those that originate within the company and have never left the
client’s organization, such as a purchase requisition.

2. Effectiveness of client’s internal controls. When a client’s internal controls are effective,
evidence obtained is more reliable than when they are weak. For example, if internal controls

4
over sales and billing are effective, the auditor can obtain more reliable evidence from sales
invoices and shipping documents than if the controls were inadequate.
3. Auditor’s direct knowledge. Evidence obtained directly by the auditor through physical
examination, observation, recalculation, and inspection is more reliable than information
obtained indirectly. For example, if the auditor calculates the gross margin as a percentage of
sales and compares it with previous periods, the evidence is more reliable than if the auditor
relies on the calculations of the controller.
4. Qualifications of individuals providing the information. Although the source of
information is independent, the evidence will not be reliable unless the individual providing it is
qualified to do so. Therefore, communications from attorneys and bank confirmations are
typically more highly regarded than accounts receivable confirmations from persons not familiar
with the business world. Also, evidence obtained directly by the auditor may not be reliable if the
auditor lacks the qualifications to evaluate the evidence. For example, examining an inventory of
diamonds by an auditor not trained to distinguish between diamonds and glass is not reliable
evidence for the existence of diamonds.
5. Degree of objectivity. Objective evidence is more reliable than evidence that requires
considerable judgment to determine whether it is correct. Examples of objective evidence
include confirmation of accounts receivable and bank balances, the physical count of securities
and cash, and adding (footing) a list of accounts payable to determine whether it agrees with the
balance in the general ledger. Examples of subjective evidence include a letter written by a
client’s attorney discussing the likely outcome of outstanding lawsuits against the client,
observation of obsolescence of inventory during physical examination, and inquiries of the credit
manager about the collectability of noncurrent accounts receivable. When the reliability of
subjective evidence is being evaluated, it is essential for auditors to assess the qualifications of
the person providing the evidence.
6. Timeliness. The timeliness of audit evidence can refer either to when it is accumulated or to
the period covered by the audit. Evidence is usually more reliable for balance sheet accounts
when it is obtained as close to the balance sheet date as possible. For example, the auditor’s
count of marketable securities on the balance sheet date is more reliable than a count 2 months
earlier. For income statement accounts, evidence is more reliable if there is a sample from the

5
 entire period under audit, such as a random sample of sales transactions for the entire year, rather
than from only a part of the period, such as a sample limited to only the first 6 months.

B. Sufficiency: The quantity of evidence obtained determines its sufficiency. Sufficiency of

evidence is measured primarily by the sample size the auditor selects. For a given audit
procedure, the evidence obtained from a sample of 100 is ordinarily more sufficient than from a
sample of 50.
Several factors determine the appropriate sample size in audits. The two most important ones are
the auditor’s expectation of misstatements and the effectiveness of the client’s internal controls.
To illustrate, assume in the audit of Jones Computer Parts
Co. that the auditor concludes that there is a high likelihood of obsolete inventory because of the
nature of the client’s industry. The auditor will sample more inventory items for obsolescence in
this audit than one where the likelihood of obsolescence Is low. Similarly, if the auditor
concludes that a client has effective rather than ineffective internal controls over recording fixed
assets, a smaller sample size in the audit of acquisitions of fixed assets may be warranted.
In addition to sample size, the individual items tested affect the sufficiency of evidence. Samples
containing population items with large dollar values, items with a high likelihood of
misstatement, and items that are representative of the population are usually considered
sufficient. In contrast, most auditors usually consider samples insufficient that contain only the
largest dollar items from the population unless these items make up a large portion of the total
population amount.

C. Combined effect: The persuasiveness of evidence can be evaluated only after considering the
combination of appropriateness and sufficiency, including the effects of the factors influencing
appropriateness and sufficiency. A large sample of evidence provided by an independent party is
not persuasive unless it is relevant to the audit objective being tested. A large sample of evidence
that is relevant but not objective is also not persuasive. Similarly, a small sample of only one or
two pieces of highly appropriate evidence also typically lacks persuasiveness. When determining
the persuasiveness of evidence, the audit or must evaluate the degree to which both
appropriateness and sufficiency, including all factors influencing them, have been met.

6
 Auditing standards require that the auditor be reasonably persuaded that inventory is not
materially misstated. The auditor must therefore obtain a sufficient amount of relevant and
reliable evidence about inventory. This means deciding which procedures to use for auditing
inventory, as well as determining the sample size and items to select from the population to
satisfy the sufficiency requirement. The combination of these four evidence decisions must result
in sufficiently persuasive evidence to satisfy the auditor that inventory is materially correct. The
audit program section for inventory will reflect these decisions. In practice, the auditor applies
the four evidence decisions to specific audit objectives in deciding sufficient appropriate
evidence.

2.5. TYPES OF AUDIT EVIDENCE

In deciding which audit procedures to use, the auditor can choose from eight broad categories of
evidence, which are called types of evidence. Every audit procedure obtains one or more of the
following types of evidence:
1. Physical examination
2. Confirmation
3. Documentation
4. Analytical procedures
5. Inquiries of the client
6. Recalculation
7. re- performance
8. Observation
A. Physical examination is the inspection or count by the auditor of a tangible asset. This type of
evidence is most often associated with inventory and cash, but it is also applicable to the
verification of securities, notes receivable, and tangible fixed assets. There is a distinction in
auditing between the physical examination of assets, such as market -able securities and cash,
and the examination of documents, such as cancelled checks and sales documents. If the object
being examined, such as a sales invoice, has no inherent value, the evidence is called
documentation. For example, before a check is signed, it is a document; after it is signed, it
becomes an asset; and when it is cancelled, it becomes a document again. For correct auditing
terminology, physical examination of the check can occur only while the check is an asset.

7
 Physical examination is a direct means of verifying that an asset actually exists(existence
objective), and to a lesser extent whether existing assets are recorded(completeness objective). It
is considered one of the most reliable and useful types of audit evidence. Generally, physical
examination is an objective means of ascertaining both the quantity and the description of the
asset. In some cases, it is also a useful method for evaluating an asset’s condition or quality.
However, physical examination is not sufficient evidence to verify that existing assets are owned
by the client (rights and obligations objective), and in many cases the auditor is not qualified to
judge qualitative factors such as obsolescence or authenticity (realizable value objective).
Also, proper valuation for financial statement purposes usually cannot be determined by physical
examination (accuracy objective).

B. Confirmation The receipt of a direct written response from a third party: For verifying the
accuracy of information. The response either in electronic or paper form. The request is made to
the client, & the client asks the third party to respond directly to the auditor. describes the receipt
of a direct written response from a third party verifying the accuracy of information that was
requested by the auditor. Confirmations are a highly regarded and often-used type of evidence.
However, confirmations are relatively costly to obtain and cause some inconvenience to those
asked to supply them. Therefore , they are not used in every instance in which they are applicable.
Confirmations may be positive or negative.
Information source

Assets
Cash in bank (example) Bank
Accounts receivable Customer
Notes receivable Maker
Owned inventory out on consignment Consignee
Inventory held in public warehouses Warehouse
Cash surrender value of life insurance Insurance co.
Liabilities
Accounts payable Creditor
Notes payable Lender
Advances from customers Customer

8
Mortgages payable Mortgagor
Bonds payable Bondholder
Owners’ Equity
Shares outstanding Registrar and transfer agent

To be considered reliable evidence, confirmations must be controlled by the auditor from the
time they are prepared until they are returned. If the client controls the preparation of the
confirmation, does the mailing, or receives the responses, the auditor has lost control and with it
independence; thus reducing the reliability of the evidence.
Auditors often attempt to authenticate the identity of the confirmation respondent, especially for
facsimile or electronic confirmation responses.

C. Documentation is the auditor’s inspection of the client’s documents and records to

substantiate the information that is, or should be, included in the financial statements. The
documents examined by the auditor are the records used by the client to provide information
for conducting its business in an organized manner, and may be in paper form, electronic
form, or other media. Because each transaction in the client’s organization is normally
supported by at least one document, a large volume of this type of evidence is usually
available. For example, the client often retains a customer order, a shipping document, and a
duplicate sales invoice for each sales transaction.

These same documents are useful evidence for the auditor to verify the accuracy of the client’s
records for sales transactions. Documentation is widely used as evidence in audits because it is
usually readily available at a relatively low cost. Sometimes, it is the only reasonable type of
evidence available.
Documents can be conveniently classified as internal and external. An internal document has
been prepared and used within the client’s organization and is retained without ever going to an
outside party. Internal documents include duplicate sales invoices, employees’ time reports, and
inventory receiving reports. An external document has been handled by someone outside the
client’s organization who is a party to the transaction being documented, but which are either
currently held by the client or readily accessible.

9
In some cases, external documents originate outside the client’s organization and end u pin the
hands of the client. Examples of external documents include vendors’ invoices, cancelled notes
payable, and insurance policies. Some documents, such as cancelled checks, originate with the
client, go to an outsider, and are finally returned to the client.

The primary determinant of the auditor’s willingness to accept a document as reliable evidence is
whether it is internal or external and, when internal, whether it was created and processed under
conditions of effective internal control. Internal documents created and processed under
conditions of weak internal control may not constitute reliable evidence. Original documents are
considered more reliable than photocopies or facsimiles. Although auditors should consider the
reliability of documentation, they rarely verify the authenticity of documentation. Auditors are
not expected to be trained or be experts in document authentication.
Because external documents have been in the hands of both the client and another party to the
transaction, there is some indication that both members are in agreement about the information
and the conditions stated on the document. Therefore, external documents are considered more
reliable evidence than internal ones. Some external documents, such as title to land, insurance
policies, indenture agreements, and contracts, have exceptional reliability because they are
almost always prepared with considerable care and often have been reviewed by attorneys or
other qualified experts.
When auditors use documentation to support recorded transactions or amounts, the process is
often called vouching. To vouch recorded acquisition transactions, the auditor might, for
example, verify entries in the acquisitions journal by examining supporting vendors’ invoices
and receiving reports and thereby satisfy the occurrence objective. If the auditor traces from
receiving reports to the acquisitions journal to satisfy the completeness objective, however, it is
not appropriate to call it vouching.
This latter process is called tracing.

D. Analytical procedures use comparisons and relationships to assess whether account balances
or other data appear reasonable compared to the auditor’s expectations. For example, an
auditor may compare the gross margin percent in the current year with the preceding years.
Analytical procedures are used extensively in practice, and are required during the planning

10
 and completion phases on all audits. We introduce the purposes of analytical procedures here
and discuss the different types of analytical procedures more extensively in Chapter 8.
Understand the Client’s Industry and Business: Auditors must obtain knowledge about a
client’s industry and business as a part of planning an audit. By conducting analytical procedures
in which the current year’s unaudited information is compared with prior years’ audited
information or industry data, changes are highlighted. These changes can represent important
trends or specific events, all of which will influence audit planning. For example, a decline in
gross margin percentages over time may indicate increasing competition in the company’s
market area and the need to consider inventory pricing more carefully during the audit. Similarly,
an increase in the balance in fixed assets may indicate a significant acquisition that must be
reviewed.
Assess the Entity’s Ability to Continue as a Going Concern: Analytical procedures are often a
useful indicator for determining whether the client company has financial problems. Certain
analytical procedures can help the auditor assess the likelihood of failure. For example, if a
higher-than-normal ratio of long-term debt to net worth is combined with a lower-than-average
ratio of profits to total assets, a relatively high risk of financial failure may be indicated. Not only
will such conditions affect the audit plan ,they may indicate that substantial doubt exists about
the entity’s ability to continue as a going concern, which, as discussed in Chapter 3, requires a
report modification.
Indicate the Presence of Possible Misstatements in the Financial Statements
Significant unexpected differences between the current year’s unaudited financial data and other
data used in comparisons are commonly called unusual fluctuations.
Unusual fluctuations occur when significant differences are not expected but do exist, or when
significant differences are expected but do not exist. In either case, the presence of an accounting
misstatement is one possible reason for the unusual fluctuation. If the unusual fluctuation is
large, the auditor must determine the reason and be satisfied that the cause is a valid economic
event and not a misstatement. For example, in comparing the ratio of the allowance for
uncollectible accounts receivable to gross accounts receivable with that of the previous year,
suppose that the ratio has decreased while, at the sometime, accounts receivable turnover also
decreased. The combination of these two pieces of information indicates a possible
understatement of the allowance. This aspect of analytical procedures is often called “attention

11
directing” because it results in more detailed procedures in the specific audit areas where
misstatements might be found.
Reduce Detailed Audit Tests: When an analytical procedure reveals no unusual fluctuations,
this implies the possibility of a material misstatement is minimized. In such cases, the analytical
procedure constitutes substantive evidence in support of the fair statement of the related account
balances, and it is possible to perform fewer detailed tests in connection with those accounts. In
other cases, certain audit procedures can be eliminated, sample sizes can be reduced, or the
timing of the procedures can be moved farther away from the balance sheet date.

E. Inquiry is the obtaining of written or oral information from the client in response to questions
from the auditor. Although considerable evidence is obtained from the client through inquiry,
it usually cannot be regarded as conclusive because it is not from an independent source and
may be biased in the client’s favor. Therefore, when the auditor obtains evidence through
inquiry, it is normally necessary to obtain corroborating evidence through other procedures.
(Corroborating evidence is additional evidence to support the original evidence.) As an
illustration, when the auditor wants to obtain information about the client’s method of
recording and controlling accounting transactions, the auditor usually begins by asking the
client how the internal controls operate. Later, the auditor performs audit tests using
documentation and observation to determine whether the transactions are recorded
(completeness objective) and authorized (occurrence objective) in the manner stated.
F. Recalculation involves rechecking a sample of calculations made by the client.
Rechecking client calculations consists of testing the client’s arithmetical accuracy and includes
such procedures as extending sales invoices and inventory, adding journals and subsidiary
records, and checking the calculation of depreciation expense and prepaid expenses. A
considerable portion of auditors’ recalculation is done by computer assisted audit software.
G. Re-performance is the auditor’s independent tests of client accounting procedures or controls
that were originally done as part of the entity’s accounting and internal control system. Whereas
recalculation involves rechecking a computation, re-performance involves checking other
procedures. For example, the auditor may compare the price on an invoice to an approved price
list, or may re-perform the aging of accounts receivable.

12
Another type of re-performance is for the auditor to recheck transfers of information by tracing
information included in more than one place to verify that it is recorded at the same amount each
time. For example, the auditor normally makes limited tests to ascertain that the information in
the sales journal has been included for the proper customer and at the correct amount in the
subsidiary accounts receivable records and is accurately summarized in the general ledger.
H. Observation is the use of the senses to assess client activities. Throughout the engagement
with a client, auditors have many opportunities to use their senses—sight, hearing, touch, and
smell—to evaluate a wide range of items. The auditor may tour the plant to obtain a general
impression of the client’s facilities, or watch individuals perform accounting tasks to
determine whether the person assigned a responsibility is performing it properly. Observation
is rarely sufficient by itself because of the risk of client personnel changing their behavior
because of the auditor’s presence. They may perform their responsibilities in accordance with
company policy but resume normal activities once the auditor is not in sight. Therefore, it is
necessary to follow up initial impressions with other kinds of corroborative evidence.
Nevertheless, observation is useful in most parts of the audit.

Evidence about Accounting Estimates

The auditors must be especially careful in considering financial statement accounts that are
affected by estimates made by management (often referred to accounting estimates) particularly
those for which a wide range of accounting methods are considered acceptable. Examples of
accounting estimates include allowances for loan losses and obsolete inventory, and estimates of
warranty liabilities. Making accounting estimates is management's responsibility, and such
estimates are generally more susceptible to material misstatement than financial statement
amounts, which are more certain in amount. Standard of auditing requires the auditors to
determine that:
a) all necessary estimates have been developed
b) the accounting estimates are reasonable, and
c) The accounting estimates are properly accounted for and disclosed.
Determining whether all necessary estimates have been developed and accounted for properly
requires knowledge of the client's business and the applicable generally accepted accounting
principles.

13
When evaluating the reasonableness of accounting estimates, the auditors may use one or more
of the following three basic approaches:
1. Reviewing and testing management's process of developing the estimates – this will often
involve evaluating the reasonableness of the steps performed by management.
2. Independently developing an estimate of the amount to compare to management's estimate.
3. Reviewing subsequent events or transactions bearing on the estimate, such as actual
payments of an estimated amount made subsequent to year-end.

Costly TYPES OF EVIDENCE

The two most expensive types of evidence are physical examination and confirmation.
Physical examination is costly because it normally requires the auditor’s presence when the
client is counting the asset, often on the balance sheet date. For example, physical examination of
inventory can result in several auditors traveling to scattered geo graphical locations.
Confirmation is costly because the auditor must follow careful procedures in the confirmation
preparation, mailing or electronic transmittal, receipt, and in the follow-up of no responses and
exceptions.
Documentation, analytical procedures, and re-performance are moderately costly. If client
personnel provide documents and electronic files for the auditor and organize them for
convenient use, documentation usually has a fairly low cost. When auditors must find those
documents themselves, however, documentation can be extremely costly.
Even under ideal circumstances, information and data on documents are sometimes complex and
require interpretation and analysis. It is usually time-consuming for an auditor to read and
evaluate a client’s contracts, lease agreements, and minutes of the board of directors meetings.
Because analytical procedures are considerably less expensive than confirmations and physical
examination, most auditors prefer to replace tests of details with analytical procedures when
possible. For example, it may be far less expensive to calculate and review sales and accounts
receivable ratios than to confirm accounts receivable. If it is possible to reduce the use of
confirmations by performing analytical procedures, considerable cost savings can be achieved.

14